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Ladies and gentlemen,
It is a pleasure to be invited to address such a distinguished audience and I would like to extend my warm thanks to Dr Toni Schönenberger and Professor Prabhu Guptara of Wolfsberg for organising this conference.
This is my first visit to Switzerland as European Commissioner for Economic and Monetary Affairs and I am very happy for the opportunity to visit your country. Switzerland is the EU's closest neighbour, and not just in the geographical sense.
The economic and financial ties between the EU and Switzerland are very strong. We cooperate on a vast range of topics and programmes. As proof of our strengthening relationship, the EU has recently opened a delegation in Bern.
With this in mind, I would like to speak today about the latest developments in financial market integration and their potential impact for the good functioning of the economy. Few places are better suited to such a topic. Zurich is firmly established as a leading banking and financial centre and financial services sit at the heart of the Swiss economy.
Today I would like to focus my remarks along three broad themes:
- I will begin with a brief macro-economic outlook of the global, Swiss and European economies.
- I will then highlight the striking progress made in European financial market integration, especially over the past decade. I will also outline the direction of our ongoing efforts.
- Finally I want to draw attention to the regulatory challenges that accompany financial market integration. In particular I want to address the need for private investors and financial authorities to preserve their ability to assess and price financial risks.
So, before I explore financial sector issues in some depth, let me set the scene with an overview of the recent developments in the world economy.
The global economy is currently experiencing one of its most dynamic periods in decades and we anticipate that the current stretch of strong global growth will continue this year and the next.
We foresee global growth to remain high at 4.8% this year and in 2008, which is only a slight deceleration from the very fast pace of 5.2% reached in 2006. This year will represent the fifth year running that global growth surpasses 4%.
The strong performance of the EU economy is helping to drive this global expansion. Last year GDP growth reached 3% in the EU, almost twice the rate of 2005. This strong economic performance is due to an increase in domestic demand that means we are now less dependent on external factors. Solid employment growth, strong investment, and a pick up in productivity should keep economic growth in the EU above 2.5% both in 2007 and 2008.
According to our spring forecasts, EU growth will reach 2.9% in 2007 compared to 2.2% for the US.
It is true that the recent weakness of the US economy is likely to have a negative impact on world economic activity compared to the brisk expansion of 2006. But we expect continued strong growth in the EU, Japan and some developing and emerging market economies, in particular in Asia, to provide an offset.
Switzerland too is growing at rates well above 2%, benefiting from both strong private consumption and investment.
Overall we consider that current, global conditions are backed by strong fundamentals and therefore, with appropriate policies, can be sustained for a number of years. However important risks remain. For instance, a harder than expected slow-down of the US economy, or geo-political events that might lead to new oil price hikes cannot be ruled out.
The fact that strong economic growth in the last couple of years has come hand in hand with growing external imbalances is another risk. The US has accrued significant current account deficits while a large current account surplus exists in East Asia and oil producing countries.
These imbalances are temporary and they can be reabsorbed orderly and gradually, in particular through a rebalancing of growth in Asia. However, a disorderly unwinding of global imbalances, although unlikely, cannot be entirely excluded. It is a low risk, high cost scenario that responsible policymakers have to keep in mind.
Finally, a possible rise in protectionism would also be a risk for the world economy although recent development around the Doha Round discussions are very encouraging.
In the European Union, two pillars of policy help to support the economy and sustain growth. The first is the European Single Market, the world's largest Internal Market which provides access to close to 500 million citizens. Its sheer size allows companies to benefit from enormous economies of scale and new opportunities for higher return to investment. At the same time, the free movement of goods, people, services and capital drives competition and allows for a more efficient allocation of production factors in Europe.
The second policy pillar that supports our economy is the Economic and Monetary Union. Its creation in 1999 was a natural complement to the single market. The euro has provided an anchor for economic stability, shielding countries from financial turbulence and exchange rate volatility. It has powered European economic integration, boosting trade and foreign direct investment.
What is more, the euro is now firmly established as a global currency to rival the US dollar or the Japanese yen. The euro's role in international trade, in the global bond market and as an official reserve currency has increased substantially since its creation. For example, in early 2005 the euro denominated bonds accounted for 46% of all outstanding bonds as opposed to 37% for the US dollar.
The euro's rise to international prominence has occurred in parallel with the development and integration of Europe's financial markets. Indeed, European financial systems have been undergoing a steady transformation for over a decade. I would like to concentrate on this topic for a moment as it carries some important implications.
European financial integration has come on leaps and bounds and we are making considerable headway towards our goal of a single European market for financial services. Today, euro denominated inter-bank and derivatives markets are fully unified and bond markets are also very much integrated. As a result, there has been a striking convergence in both short term and long term interest rates.
The integration of European financial markets officially began in 1985 with the launch of the Single Market initiative. And yet it was the introduction of the euro in 1999 that really accelerated this process.
Prior to the single currency, exchange rate risk was a major impediment to the integration of national financial markets. With the launch of the euro, this risk on the bulk of cross border financial flows within Europe was eliminated. It unleashed investor demand for cross border financial services and instruments and has driven forward the process of financial integration.
When the euro removed exchange rate risk, attention shifted to remaining obstacles to integration, namely in the field of regulation. The Financial Services Action Plan, which was also launched at the end of the 90s, provides a blueprint for a common regulatory framework for the European financial services market.
The fact that the plan was implemented almost in its entirety by the 2005 deadline was a remarkable achievement. Once the action plan is transposed into national laws, much of the legislative framework for an integrated financial market will be in place.
Progress in integration has been uneven across different sectors, it is true. However, the process of financial market integration is continuing apace and we have identified our priorities for further action in the years ahead.
A full transposition of the FSAP into national law is at the top of our agenda. Let me give a couple of examples. One example is the implementation of the Markets in Financial Instruments Directive (MiFID) which is designed to facilitate cross-border investment transactions. Another is the implementation of the Basel II reform which is overhauling the regulatory capital regime for banks and where Europe is forging ahead despite US reluctance.
The increasing activity in cross border banking mergers and acquisitions is further evidence of accelerating financial integration in Europe. But it means that ensuring more clarity and transparency in supervision practices must become a high priority. Supervisory arrangements that are better adapted to the reality of today's financial markets should ensure an increasingly efficient and safe EU financial sector.
We clearly have some way to go, despite the considerable progress we have made over the last decade. But the benefits that stem from further integration should prove our efforts are worthwhile. There is ample theoretical and empirical evidence that shows a causal link between financial development and economic growth. An even more integrated and efficient European financial market could be a crucial instrument for fostering wealth and employment in Europe.
Here in Switzerland you know very well that growing financial integration brings important opportunities. But I am sure that you are also aware of some of the challenges that accompany financial integration. For the final part of my speech I would like to focus on one particular challenge: namely, the issue of investors' and public authorities' ability to properly assess and price financial risk.
Today's financial conditions are exceptional by historical standards. For much of the past decade, the international financial system has been characterised by low interest rates and ample liquidity. This combination has led to a search for yield and a generalised increase in investor appetite for risk. As a result, ever more complex financial instruments and sophisticated techniques for risk management and credit risk transfer have developed.
Access to these new instruments and techniques allows a much more efficient pricing and risk pooling among investors. It has revolutionised the functioning of the modern financial system.
Indeed, changes in the financial system have generated impressive financial innovations in recent years. In the past, investors were forced to expose themselves to packages of risks and demanded a corresponding risk premium. Today, investors need only assume their desired risk exposure, allowing them to tailor the risk profile in their investment portfolio to their exact requirements.
As a result, risk levels are not only lower for individual investors but there is much to suggest that the financial system as a whole has become more resilient to adverse shocks.
The rapid growth and innovation in the market for credit derivatives for example, has made substantial improvements in the way credit risk is managed and has facilitated a broad distribution of risk outside the banking system.
Such changes probably improve the overall efficiency and resiliency of financial markets. They spread risk more widely, make it easier to actively trade credit risk, and they facilitate the participation of a large and very diverse pool of non-bank financial institutions, like hedge funds, in the business of credit.
However, despite the benefits of financial instruments and financial innovation to financial resilience, there are also some concerns and unease amongst us.
A foremost concern is that the high liquidity generating investor search for yield may have resulted in a structural change in the pricing of risk. This has raised concerns about the mis-pricing of risk throughout the financial system.
There are a number of telling signs on that front:
Firstly, government benchmark yields are very low. Taking the last 60 years, nominal 10 year government bond yields are close to record lows in Japan, Germany and the US (around 2%, 4.5% and 5% respectively). This despite the recent bond sell-off.
Corporate spreads are also at a low level with BBB rated borrowers yielding between 75 and 150 bps over government benchmark bonds in the developed economies. In addition, sovereign spreads in emerging markets are at very low levels. The Morgan Stanley emerging market bond spread index has declined to roughly 160 basis points.
Furthermore, volatility indices are low, implying reduced investor risk perception. At the same time, stock markets have matched the record highs reached in 2000 and credit standards have slipped, encouraging private sector borrowing. Euro area households have borrowed from banks at a record pace during 2006 with a year-on-year growth rate reaching almost 10%.
All of these signs indicate that the pricing of risk in financial markets has changed. Against this background, a correction in financial markets and asset prices might lead to unforeseen consequences.
Therefore, the benefits of financial innovation should not make us complacent about financial stability. A more efficient distribution of risk may have reduced the probability of a systemic financial crisis. But, it has probably increased the costs of such a crisis, should it occur.
There are two main reasons why this might be the case:
- First, the markets for many of the financial instruments for risk transfer, such as credit derivatives, are highly complex. The functioning of these markets is largely untested under conditions of stress. There is a concern that these markets could suddenly become illiquid in crisis conditions as participants all seek to exit at the same time.
- Second, there is inevitable moral hazard for the originators of risk in the financial system, when that risk can be easily transferred to others that are in turn not able to price for such added risk. Given the possibilities for risk transfer and the pressure of competition within the financial system, there is a concern that standards of risk management could decline or have already declined.
The development of financial products such as credit derivatives, securitised assets or default swaps - to name just a few - represents a major challenge for the authorities responsible for safeguarding financial stability. This is because the distribution of risk has made it harder to locate potential vulnerabilities in the global financial system.
In the past, we worried about high levels of credit risk warehoused in the banking system and organised our supervisory arrangements accordingly. Today, the location of vulnerabilities in the financial system is far less obvious and the authorities must focus on a much wider range of potential sources of risk exposure.
Moreover, information on these risks is not readily available for regulatory oversight in each country as financial institutions engage increasingly at a global level in off-balance sheet operations and the markets for risk-transfer instruments remain opaque. The complexity of the instruments involved mean that it is difficult to assess underlying exposure to risk.
Hedge funds, as one of the most active vehicles for the use of innovative financial instruments, have recently become synonymous with excessive risk taking in the financial system.
This is perhaps an unfair assessment as they provide market liquidity, enhance price discovery and offer a vehicle for portfolio diversification. Hedge funds have become a major source of financial engineering and innovation and are responsible for creating many of the complex financial instruments that have emerged in recent years.
But while hedge funds remain small relative to the overall size of the global asset management industry, their leveraged investment strategies amplify their potential impact on financial-market developments and eventually, on the non-financial sectors of the economy.
In the EU we are working in cooperation with our global partners to improve our ability to oversee such sources of risk exposure. Our ongoing efforts are demonstrated in recent discussions that have taken place among EU Finance Ministers in May and among G8 leaders during their meeting in Heiligendamm last week.
Overall, I remain positive about financial innovations and I would like to emphasise that the resilience displayed by the international financial system to recent shocks – for example the equity price corrections in 2006 and earlier this year – provides indirect evidence that such innovation has indeed resulted in a more efficient distribution of risk.
However, in the absence of adequate information on credit risks, the financial and monetary authorities cannot directly monitor the extent to which specific concentrations of risk exposure may have re-emerged. The simple fact is that supervisors' knowledge on where and how much risk lie in the global financial system has probably declined as financial innovation has increased. In many ways, supervisors are often asked to make an "act of faith" in the ability of the system to safeguard its own stability.
Conclusion
Ladies and Gentlemen, let me conclude my intervention.
The current, strong performance of the European and Swiss economies is forecast to continue over this year and the next. Meanwhile, the progressive construction of fully integrated economic and financial markets in the Union is well underway.
These developments coincide with a wave of innovation underway in financial markets that already offers substantial benefits to both the efficiency and stability of our financial system. The extent of these benefits will depend, in part, on how we can keep up with the pace of change in the market and prepare the best regulatory framework for this new environment.
I welcome the ongoing discussions in the EU and the G8 on how to assess stability in a modern financial system. But this debate has only just begun. As the structure and functioning of the financial system continues to change, the framework for safeguarding financial stability must also evolve. This is particularly the case in the EU, where the financial system is set for major transformation as the integration of the various national financial systems proceeds.
