Speech by Mitja Gaspari, Governor of the Bank of Slovenia, at the international conference on the Restructuring of the Financial Sector in Small Developed Economies

10/26/2006 / Press release

(the spoken version takes precedence)

I would like to welcome you all to the Bank of Slovenia’s conference on the restructuring of the financial sector in small developed economies.

In today’s world we speak of an age of progressive economic integration, at a regional and global level. Globalisation is a key word in any discussion of economics that tries to explain rapid global economic development or the recent rapid development of individual countries.

Globalisation is increasing the need for coordination and a stability-focused monetary policy on the part of the world’s largest economies, particularly in a period of increasing global imbalances. In complex economic flows, a disturbance in a single monetary policy can trigger a financial crisis because of increased volatility in financial markets for major world currencies. The consequences of such a financial crisis would hurt small, open economies the most, unless they were adequately prepared.

The results of globalisation are growing international trade and an increase in the flow of capital between countries. Their openness means that small economies are most exposed to the effects of globalisation; they cannot hold out against these effects, but can in the best case exploit them for their own benefit. The economic openness of small economies is most frequently expressed in a high ratio of trade to GDP, and a high level of financial openness and integration into international financial flows.

Slovenia is undoubtedly one of those countries that have been involved in the process of economic globalisation in recent years. Dynamic foreign trade has been accompanied by growing financial flows with the rest of the world. The Slovenian private sector’s debt to the rest of the world now stand at more than 80% of GDP, while just five years ago they were merely half this value. The private sector’s claims against the rest of the world have reached 60% of GDP this year, but were less than 40% of GDP five years ago. With debt equivalent to 51% of GDP and claims equivalent to 33% of GDP, Slovenia’s financial sector accounts for the majority of these financial debt and claims vis-à-vis the rest of the world. This is a reflection of the rapid deepening of financial integration. EU membership and the preparations for introducing the euro.

Here the question is raised of what benefits increased financial integration brings to individual small, open economies. First, a greater level of integration leads to greater competition in the domestic market, which encourages greater efficiency in the financial sector. Second, integration alters market structure. The financial market becomes larger, financial institutions are able to effectively exploit economies of scale and economies of related products, while the larger financial market simultaneously allows for a higher level of specialisation. Consumers of financial services thus gain a wider choice of products. Third, financial integration reduces information and transaction costs, which is particularly the case with the monetary union. Some economists also cite the importance of distinguishing between market integration and policy integration. While market integration primarily removes the barriers between markets in the free flow of finances, policy integration requires the coordination and harmonisation of guidelines for the functioning of individual sectors and segments of the financial market.

The liberalisation of international capital flows requires a great deal of flexibility in the domestic financial sector and an ability to respond rapidly to changes in the direction and size of international financial flows. Exploiting the benefits of financial integration requires at least minimal coordination of economic policy, as autonomous changes in policy can give rise to increased volatility in financial markets. However, the need for coordination represents a potential risk of a restriction in competition between different ways of managing economic policy, or the undermining of aspirations to maintain the stability of the domestic financial system using various instruments. The tendency to centralise the regulation of financial markets in the EU, which does not take account of the specific features of the individual national financial systems and financial markets, can be interpreted as one form of such endeavours.

Despite the awareness that financial integration is a key factor in the development and modernisation of financial systems in the EU, integration processes are not of equal size and intensity in all segments of the financial system. Economic analysis based on quantitative indicators has established that the highest level of integration has been achieved on the interbank money market for unsecured loans, with the capital market for government securities at a slightly lower level, while, worryingly, the lowest level is in the area of retail banking, with consumer and housing loans.

Why there are major barriers to the integration of the European banking system is a complex issue, but undoubtedly one of the reasons lies in the relatively complex regulation of national banking markets. Until recently, the consolidation of banking systems mainly proceeded within national borders, as the value of cross-border mergers and acquisitions of banks was less than 20% of the total value of such deals between banks in the EU. And again in this instance small economies were more successful, with a smaller number of banks and, in general, greater exposure to the entry of foreign credit institutions or cross-border banking services. Only in the last year or two have we seen an increase in cross-border mergers and acquisitions, and these examples were high-profile mainly because they involved the largest banks in the largest members of the eurozone.

In smaller countries, particularly the new EU member-states, integration proceeded in parallel with the intensive process of the privatisation and liberalisation of banking systems during the period of economic and social transition. This was joined during the negotiations over EU membership by the intensive adjustment of the legal arrangements in the candidate countries governing the operation and conversion of financial institutions. The overall feature of these processes was the one-way cross-border expansion of financial institutions, banks in particular, from the west to the east. Another feature of the restructuring of the European banking industry is that bank privatisation is yet to embrace that part of the banking industry in the old EU member-states that is not under private ownership.

Today the number of European banks is falling relatively rapidly, while their interdependence is rising. Despite intense encouragement from the European Commission for the creation of pan-European banks, the conquest of east European financial markets via bank branches remains deeply rooted. With the enlargement of the EU, the issue of the barriers to international business was replaced with new challenges in the area of regulation and risk management in an increasingly unified European financial services market. Given the prevailing model for banking-based financial systems in continental Europe, these challenges were and continue to be faced mainly by bank supervisors.

While the integration process in the regulation of financial services in the EU has been finalised de facto, only relatively few of the approximately 6,200 European banks do cross-border services. Among these, three groups can be distinguished. Many banks, smaller banks in particular, remain focused on their national market, but have expanded into markets in other countries via branches, which are supervised by the supervisor in the home country of the parent bank. At the same time, there have arisen some banking groups, generally in the old EU member-states, where cross-border services account for a major proportion of business, and some banking groups whose business outside the home country of the parent bank is already of systemic importance to the host country. For such groups of banks and financial institutions, the question of supervision is no longer simple, while scenarios for the measures to be taken in the event of financial crises are even more complicated. Are we ready to face a crisis involving a bank, a financial institution or several institutions that could spread outside national borders with extraordinary rapidity?

Cooperation between bank supervisors has strengthened in recent years, including of the CEBS Directive on cooperation between supervisors in the country in which the consolidated financial statements are compiled, and supervisors in the country where the branch of the institution is located. In the event of a financial crisis in several countries, there would be reliance on the Memorandum of Understanding between the bank supervisors, central banks and finance ministries of EU member-states, which envisages and defines the ways in which measures are coordinated. The speed at which information is transmitted and the formulation of a comprehensive overview of the situation are the key to controlling the crisis. Here the complexity of the division of responsibility for supervision between the supervisors of the parent institution and the branches, and of risk management between the parent institution and the branches, and the question of when to activate an individual national guarantee scheme demands further elaboration of crisis scenarios. Another of the elements is the question of the burden sharing in the event of interventions to limit the damage from a financial crisis. Such questions also form part of overall assessments of the restructuring of financial systems.

Let me conclude with this thought: given vital risk management in financial services and adequate supervision of financial institutions, we cannot ignore the effectiveness of financial systems. They should transfer financial surpluses at minimal cost to the investors with the best projects. Ensuring the same rules for all, competition in the market for financial services, and transparency of business must remain an integral part of the development of financial systems. Continuing with the restructuring of the European financial industry within these frameworks is a prerequisite for it to be able to support economic growth to a satisfactory degree, thus contributing indirectly to greater wellbeing.

I believe that today’s conference will encourage debate about the restructuring of the financial systems of small, open economies. At the same time, I wish you a very pleasant time at this conference as the honoured guests of the Bank of Slovenia.