European Monetary System

terms of price stability. This is not only a requirement explicitly set by

the Treaty of Maastricht, it is also, in the opinion of most, the "new

anchor" that purely fiduciary currencies need after the gold anchor is

abandoned.

3. My remarks, however, will focus on another, less fundamental but

still important novelty of the monetary constitution that has just come

into existence. It is the novelty of the abandonment of the coincidence

between the area of jurisdiction of monetary policy and the area of

jurisdiction of banking supervision. The former embraces the 11 countries

that have adopted the euro, while the latter remains national. Just as we

have no precedent of any comparable size of money disconnected from states,

we have no precedent for a lack of coincidence between the two public

functions of managing the currency and controlling the banks.

In the run-up to the euro this feature of the system was explored,

and some expressed doubts about its effectiveness. I will tonight examine

the problems of banking supervision in the euro area. The plan of my

remarks is the following. I will first review the existing institutional

framework for the prudential control of banks in EMU. I will then examine

the likely scenario for the European banking industry in the coming years.

Against this institutional and industry background, I shall then discuss

the functioning of, and the challenges for, banking supervision and central

banking in the euro area, both in normal circumstances and when a crisis

occurs.

II. INSTITUTIONAL FRAMEWORK

4. The origin and developments of modern central banks are closely

linked to key changes undergone by monetary systems over the past two

centuries. Such changes could, very sketchily, be summarised as follows.

First, paper currency established itself as a more convenient means of

payment than commodity currencies. Second, commercial bank money (bank

deposits) spread as a convenient substitute for banknotes and coins. Third,

the quantity of money was disconnected from the quantity of gold. Thus, a

double revolution in the technology of the payment system, the advent of

banknotes and that of cheques or giros, has shaped the functions that most

central banks performed over this century: monetary policy and prudential

supervision. Man-made money made monetary policy possible. The fact that a

large, now a predominant, component of the money stock was in the form of

commercial bank money made banking supervision necessary.

Ensuring confidence in the paper currency and, later, in the

stability of the relationship, one could say the exchange rate, between

central bank and commercial bank money, were twin public functions, and, in

general, they were entrusted to the same institution. Just as money has

three well-known economic functions - means of payment, unit of account and

store of value - so there are three public functions related to each of

them. Operating and supervising the payment system refers to money as a

means of payment; ensuring price stability relates to money as a unit of

account and a store of value; and pursuing the stability of banks relates

to money as a means of payment and a store of value. In each of the three

functions commercial banks have played, and still largely play, a crucial

role.

In an increasing number of countries the original triadic task

entrusted to the central bank has now been abandoned in favour of a

"separation approach", according to which banking supervision has been

assigned to a separate institution. Following the recent adoption by the

United Kingdom and Luxembourg of the separation approach, only two of the

12 countries represented in the Basle Committee on Banking Supervision

(Italy and the Netherlands) have the central bank as the only authority

responsible for banking supervision. In all systems, however, whether or

not it has the task of supervising the banks, the central bank is deeply

involved with the banking system precisely because the banks are primary

creators of money, providers of payment services, managers of the stock of

savings and counterparties of central bank operations. No central bank can

ignore the need to have a concrete and direct knowledge of "its" banking

system, i.e. the banking system that operates in the area of its monetary

jurisdiction.

Personally, I have an intellectual attachment to, as well as a

professional inclination for, the central bank approach to banking

supervision, due partly to the fact that I spent most of my professional

life in a central bank which is also to this day the banking supervisor.

Yet I can see, I think, the arguments that have led a growing number of

industrialised countries to prefer the separation approach. Such arguments

basically point to the potential conflict between controlling money

creation for the purpose of price stability and for the purpose of bank

stability. On the whole, I do not think that one model is right and the

other wrong. Both can function, and do function, effectively; if

inappropriately managed, both may fail to satisfy the public interest for

which banks are supervised.

5. Against this background, let me now describe the institutional

framework currently adopted by the Treaty. As my description will refer to

the area in which both the single market and the single currency are

established, it will not specially focus on the problems of the so-called

"pre-in" countries, including the United Kingdom.

The current institutional framework of EMU (i.e. the single market

plus the single currency) is a construct composed of two building blocks:

national competence and co-operation. Let me first briefly review the main

aspects of these two building blocks and then see how the Eurosystem

relates to them.

First, national competence. In a market based on the minimum

harmonisation and the mutual recognition of national regulatory standards

and practices, the principle of "home country control" applies. According

to this principle every bank has the right to do business in the whole area

using a single licence, under the supervision, and following the rules, of

the authority that has issued the licence. The full supervisory

responsibility thus belongs to the "home country". This allows, inter alia,

the certain identification of the supervisor responsible for each

institution acting as a counterparty to the monetary policy operations of

the Eurosystem. The only exception to this principle - the "host country"

competence for the supervision of liquidity of foreign branches - is no

longer justified now that the euro is in place; hence it should soon be

removed.

Second, co-operation. In a highly regulated industry such as banking,

a single market that retains a plurality of "local" (national) supervisors

requires close co-operation among supervisors to safeguard the public good:

namely, openness, competition, safety and soundness of the banking

industry. EU directives (the 1st and 2nd Banking Directives and the so-

called BCCI Directive) lay the foundations for such co-operation, but they

do not contain specific provisions or institutional arrangements to this

end. They limit themselves to stating the principle of co-operation among

national authorities and to removing obstacles to the exchange of

information among them.

6. How does the Eurosystem relate to this construction? Essentially

in two ways. First, the Treaty assigns to the Eurosystem the task to

"contribute to the smooth conduct of policies pursued by competent

authorities relating to the prudential supervision of credit institutions

and the stability of the financial system" (Article 105 (5)). Given the

separation between monetary and supervisory jurisdictions, this provision

is clearly intended to ensure a smooth interplay between the two. Second,

the Treaty gives the Eurosystem a twofold (consultative and advisory) role

in the rule-making process. According to Article 105 (4), the ECB must be

consulted on any draft Community and national legislation in the fields of

banking supervision and financial stability; and, according to Article 25

(1) of its Statute, the ECB can provide, on its own initiative, advice on

the scope and implementation of the Community legislation in these fields.

It should be borne in mind that central banks are normally involved in the

process of drawing up legislation relating to, for example, regulatory

standards, safety net arrangements and supervision since this legislation

contributes crucially to the attainment of financial stability.

7. Two observations should be made about the institutional framework

just described. First, such an arrangement establishes a double separation

between central banking and banking supervision: not only a geographical,

but also a functional one. This is the case because for the euro area as a

whole banking supervision is now entrusted to institutions that have no

independent monetary policy functions. The separation approach that was

chosen for EMU has effectively been applied not only to the euro area as a

whole, but to its components as well. Indeed, even in countries where the

competent authority for banking supervision is the central bank, by

definition this authority is, functionally speaking, no longer a central

bank, as it lacks the key central banking task of autonomously controlling

money creation.

The second observation is that the Treaty itself establishes (in

Article 105 (6)) a simplified procedure that makes it possible, without

amending the Treaty, to entrust specific supervisory tasks to the ECB. If

such a provision were to be activated, both the geographical and the

functional separation would be abandoned at once. The fact that the

Maastricht Treaty allows the present institutional framework to be

reconsidered without recourse to the very heavy amendment procedure

(remember that such procedure requires an intergovernmental conference,

ratification by national parliaments, sometimes even a national referendum)

is a highly significant indication that the drafters of the Treaty clearly

understood the anomaly of the double separation and saw the potential

difficulties arising from it. The simplified procedure they established

could be interpreted as a "last resort clause", which might become

necessary if the interaction between the Eurosystem and national

supervisory authorities turned out not to work effectively.

III. INDUSTRY SCENARIO

8. When evaluating the functioning of, and the challenges to, banking

supervision in the current institutional framework, two aspects should be

borne in mind. First, the advent of the euro increases the likelihood of

the propagation of financial stability problems across national borders.

For this reason a co-ordinated supervisory response is important at an

early stage. Second, the sources of banks' risks and stability problems

depend on ongoing trends that are not necessarily caused by the euro, but

may be significantly accelerated by it. On the whole, we are interested not

so much in the effects of EMU or the euro per se, as in the foreseeable

developments due to all factors influencing banking in the years to come.

9. It should be noted at the outset that most banking activity,

particularly in retail banking, remains confined to national markets. In

many Member States the number, and the market share, of banks that operate

in a truly nationwide fashion is rather small. Although banks'

international operations have increased, credit risks are still

predominantly related to domestic clients, and the repercussions of bank

failures would be predominantly felt by domestic borrowers and depositors.

10. Assessing the internationalisation of euro area banks is a

complex task because internationalisation can take a number of forms. One

is via cross-border branches and subsidiaries. Although large-scale entry

into foreign banking markets in Europe is still scarce, reflecting

persisting legal, cultural and conduct-of-business barriers (less than 10%

on average in terms of banking assets in the euro area; Table 1), there are

significant exceptions. The assets of the foreign branches and subsidiaries

of German and French banks account for roughly a third of the assets of

their respective domestic banking systems (Table 2). The Dutch banking

system is also strongly diversified internationally.

Another way to spread banking activity beyond national borders is

consolidation. Cross-border mergers or acquisitions still seem to be the

exception, although things have started to change. The recent wave of

"offensive" and "defensive" banking consolidation has mainly developed

within national industries, thus significantly increasing concentration,

particularly in the smaller countries (Table 3); it may be related not so

much to the direct impact of EMU as to globally intensified competition and

the need to increase efficiency.

In the coming years internationalisation is likely to increase,

because, with the euro, foreign entrants can now fund lending from their

domestic retail deposit base or from euro-denominated money and capital

markets. The relatively large number of foreign branches and subsidiaries

already established could be a sufficient base for an expansion of

international banking activity (Table 4) since a single branch, or a small

number of branches, may be sufficient to attract customers, especially when

they are served through direct banking techniques, such as telephone and

Internet banking. Also, the cross-border supply of services on a remote

basis is likely to spread as direct banking techniques develop. As to cross-

border mergers and acquisitions aimed either at achieving a "critical mass"

for wholesale financial markets, or at rapidly acquiring local expertise

and customers in the retail sector, they may remain scarce because the cost

savings from eliminating overlaps in the retail network are likely to be

limited and the managerial costs of integrating different structures and

corporate cultures are substantial.

11. However, banks' internationalisation does not provide the full

picture of the interconnections of banking systems. As "multi-product"

firms, banks operate simultaneously in many markets which have different

dimensions: local, national, continental (or European) and global. The

advent of the euro is likely to enlarge the market for many banking

products and services to the continental dimension; this will

"internationalise" even those banks that remain "national" in their branch

networks and organisation.

The formation of the single money market in the euro area has largely

taken place already. The dispersion in the euro overnight rate across

countries, as reported by 57 so-called EONIA banks, fell in January from

around 15 to 5 basis points. The variation between banks has been

significantly greater than between countries. The TARGET system has rapidly

reached the dimension of Fedwire, with a daily average value of payments of

E1,000 billion, of which between E300 and E400 are cross-border. The ever

stronger interbank and payment system links clearly increase the

possibility of financial instability spreading from one country to another.

Through these links the failure of a major bank could affect the standing

of its counterparties in the entire euro area. On the other hand, the

deeper money market could absorb any specific problem more easily than

before.

As regards the capital markets, the effects of the euro will take

more time to manifest themselves, but are likely to be substantial. The

single currency offers substantial opportunities for both debt and equity

issuers and investors. The increase in the number of market participants

operating in the same currency increases the liquidity of the capital

markets and reduces the cost of capital. The low level of inflation and

nominal interest rates and diminishing public sector deficits are

additional supporting factors of capital market activity, especially

private bond market activity which has so far been relatively limited

(Table 5). Banks will thus operate in increasingly integrated capital

markets and will be exposed to shocks originating beyond their national

borders.

As to corporations, they may concentrate their operations (treasury,

capital market and payment management) in a single or few "euro banks",

while the disappearance of national currencies may break links between

firms and their home country "house bank". This dissociation would make the

domestic economy indirectly sensitive to foreign banks' soundness, thus

creating another propagation channel of banking problems across countries.

12. When considering the industry scenario for the coming years, the

viewpoint has to be broadened beyond the impact of the euro. Rather than

the exclusive, or even primary, force for change, the euro is expected to

be a catalyst for pre-existing trends driven by other forces. The recent

ECB report prepared by the Banking Supervision Committee on "Possible

effects of EMU on the EU banking systems in the medium to long term" gives

a comprehensive analysis of such trends, which can be summarised as

follows. First, regulation: the industry has yet to feel the full impact of

such fundamental, but relatively recent, regulatory changes as those

related to the single market legislation. Second, disintermediation: other

financial intermediaries and institutional investors will grow relative to

banks, pushed by demographic and social changes, as well as by the

increasing depth and liquidity of the emerging euro area-wide capital

market. Disintermediation is expected to take the form of increasing

recourse to capital market instruments relative to bank loans by firms, and

diminishing investment in deposits by households relative to mutual funds

and related products. Third, information technology: bank products,

operations and processes are changing rapidly, while technology offers

increasing possibilities for dissociating the supply of a large number of

services from branches and face-to-face contact with customers. The current

tendency in the EU banking systems to reduce over-branching and over-

staffing will grow stronger.

These factors will increase competition, exert pressure on

profitability and oblige banks to reconsider their strategies. Such effects

are already visible throughout the EU. They produce changes in

organisation, new products and services, mergers, strategic alliances, co-

operation agreements, etc. They also involve strategic risks, because the

pressure for profitability and some losses of revenue due to the euro, for

example from foreign exchange, may push some banks to seek more revenue

from unfamiliar business or highly risky geographical areas. Inadequate

implementation of new technologies or failure to reduce excess capacity may

also affect banks' long-term viability. In the short term, the structural

adaptation process could be made more difficult by the combination of

factors like the protracted financial difficulties of Asia and Russia, or

the preparations for the year 2000.

IV. CURRENT SUPERVISION

13. Against the background of the institutional framework and the

industry scenario I have outlined, let me now turn to the functioning of

banking supervision in the euro area. Two preliminary observations. First,

the objective of financial stability pursued by banking supervisors is only

one in a range of public interests, which also includes competition policy

and depositor and investor protection policy. Second, current supervision

and crisis management involve different situations and procedures and will

therefore be examined in sequence.

14. Starting with current supervision, let me consider banking

regulation first. As observed earlier, the regulatory platform for the euro

area banking industry combines harmonised rules with country-specific (non-

harmonised, but mutually recognised and hence potentially competing) rules.

The harmonised part of the platform includes most of the key

prudential provisions that have been developed in national systems over the

years. More than 20 years ago (1977), the 1st Banking Co-ordination

Directive adopted a definition of a credit institution and prescribed

objective criteria for the granting of a banking licence. In 1983 the first

Directive on carrying out supervision on a consolidated basis was approved,

and in 1986 the rules relating to the preparation of the annual accounts

and the consolidated accounts of banks were harmonised. In 1989 the 2nd

Banking Co-ordination Directive (which became effective on 1 January 1993)

marked the transition from piecemeal to comprehensive legislation,

introducing, inter alia, the principle of "home country control". A number

of other specific directives have subsequently addressed the main aspects

of the regulatory framework - notably, own funds, solvency ratios and large

exposures. A Directive imposing deposit guarantee schemes supplemented the

legislation in support of financial stability. All in all, the European

Union, including the euro area, now has a rather comprehensive "banking

law" consistent with the Basle Committee's rules and with the 1997 Core

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