Barriers to Integration

The ECB points to national authorities as blocks to deeper European financial integration. How far is this fair?

Claudia Buch discussed European financial integration in Paris last week. More integrated financial markets could bring a range of benefits to the European economy, such as enhanced competition and better risk-sharing within the Eurozone. So alongside ensuring the safety and soundness of Eurozone banks, the ECB has made promoting financial integration a part of its institutional mission.

A familiar story, of two halves

Buch offered an account of “slow but gradual” progress that was similar to that of her predecessor as Supervisory Board Chair Andrea Enria in a speech last October.

On the positive side, the past decade has seen significant institutional integration. The establishment of the Single Supervisory Mechanism (SSM), with ECB Banking Supervision at its core, has brought consistent supervision of a single rulebook for European banks. And the parallel creation of the Single Resolution Mechanism (SRM) has led to the development of a common framework for dealing with failing banks. These major reforms have laid the foundations for a seamless single banking market within the Eurozone.

Buch acknowledged, however, that this institutional integration remains incomplete and has yet to deliver radical change in the structure of the European banking market. EU governments have not been able to agree on a centralised European Deposit Insurance Scheme (EDIS), intended as the third pillar (alongside the SSM and SRM) of the Banking Union.

Meanwhile the Eurozone banking sector has seen few cross-border mergers (despite the ECB clarifying that it would not oppose cross-border mergers as such). European banks have made limited use of the option to set up branches in different EU countries, and national regulators have continued to ring-fence liquidity and capital locally, refusing to grant waivers to allow banks to pool resources among the European subsidiaries. Partly as a result, European banking remains overwhelmingly domestic, with only 7% of lending taking place across borders with the Eurozone. The story is similar for capital markets, where the results of the EU Capital Markets Union (CMU) project have yet to prove transformative.

(In keeping with her more academic style, Buch also offered a more in-depth analysis of ECB price- and quantity-based indicators of financial integration. These show a modest increase in cross-border lending over the past decade along with gradual convergence in rates charged and offered to customers. Buch suggested that even without the presence of foreign banks in a given country, the possibility that rivals could enter the market could exert competitive pressure on local banks.)

Someone else’s responsibility?

The clear subtext of Buch’s speech was that the barriers to deeper European financial integration lie in national capitals. The ECB could advocate and advise (proposing, for example, a solution to the concerns underlying national ring-fencing), but progress depends on national authorities agreeing to further harmonisation of rules and pooling of powers and risks at European level. (Privately, some ECB officials go further and complain of national regulators actively hindering greater integration, such as by pressing banks not to convert local subsidiaries into branches.)

At one level this is simply a statement of constitutional realities. Buch is of course right that the power to legislate on EDIS or CMU lies with EU governments, not the central bank. And current EU law does indeed give the power to grant or withhold capital waivers exclusively to national authorities. Yet it is important to recognise that there are areas where ECB policy has, at least at the margin, contributed to market dynamics that have hindered greater financial integration.

Perhaps the most significant feature of the Eurozone banking sector in the last decade has been chronically low profitability. Fuelled by the saturation of the banking market in many countries (Germany is said to have more bank branches than bakeries) as well as regulatory costs and legacy problems from the financial crisis, this has limited the pool of banks able to undertake the mergers and acquisitions that could consolidate the sector. (Saturated markets also favour domestic over cross-border consolidation, as the opportunities for cost-cutting are typically more obvious: hence most recent European bank M&A activity has been domestic, such as the proposed BBVA-Sabadell merger in Spain.) And potential takeover deals must always compete internally for capital against banks’ other investment priorities, such as developing new products.

Lately, as interest rates have risen, European banks profits have recovered – with aggregate return on equity hitting 10% in 2023, up from just 6% in 2015. Could this provide the finance for a long-awaited wave to consolidation? Perhaps, but the ECB has been notable by its silence on this possibility. On the contrary, in a recent interview Buch urged banks to use current higher profits to bolster their resilience by modernising IT systems – and building up capital buffers.

Objective decisions

Safety and soundness remains, after all, ECB Banking Supervision’s primary objective. For all its potential benefits, including to systemic stability, it seems that promoting greater financial integration simply cannot compete with that.