European Monetary System

EU. Once the accession of new Member States is decided, these countries

have to fulfil the so-called convergence criteria, if they want to join the

euro area. The euro area can finally only be enlarged if the European

Council, following an assessment by the ECB and the European Commission,

decides that further Member States of the EU are ready to adopt the single

currency. New countries joining the euro area will be a challenge for us.

For example, we will have to integrate the respective economy fully in our

area-wide analysis of monetary, financial and other economic developments

in the euro area. Enlargement is a challenge we clearly welcome. I have no

doubts that we can master it, not least as the EC Treaty outlines a clear

and transparent procedure for countries wishing to join the euro area. In

simple terms, this can be viewed as involving three phases. First, a

candidate country must join the European Union, for which certain

requirements must be met. Second, the candidate is expected to join the new

exchange rate mechanism, ERM II. Third, as mentioned earlier, the country

must fulfil the convergence criteria. In addition to fiscal discipline and

inflation control, these criteria include a relatively low level of long-

term interest rates and stable exchange rates.

Let me conclude. Monetary policy cannot solve all of the economic

challenges facing the euro area, in particular those concerning the urgent

need to reduce the high level of structural unemployment. National

governments are responsible for carrying out the required structural

reforms. The Eurosystem makes its best contribution to area-wide growth and

employment prospects by credibly focusing on the maintenance of price

stability in the euro area.

I am confident that the monetary policy strategy adopted by the

Governing Council of the ECB last October has been successful - and the

monetary policy decisions that have been based on it over the last eight

months - serve the fulfilment of this objective. Nevertheless, we will not

become complacent; on the contrary, we will have to continue to invest

substantially in analysing the structure of the euro area economy, and in

understanding the monetary policy transmission mechanism and the

information content of the various monetary and economic indicators.

Monetary policy is most effective when it is credible. Transparent

and accountable policy-making can help to build up a reputation and

credibility. Effective direct communications with the public, including the

financial markets, other policy makers and the media requires that we speak

with one voice in an even-handed way with our diverse counterparties and

audience. Successfully refining our area-wide communications, aimed at

making our strategy, and the monetary policy based on it, transparent so

that it can be well understood by the large and varied population we serve,

is one of the challenges faced by the Eurosystem and, by implication, one

of our priorities.

***

EMU AND BANKING SUPERVISION

Lecture by Tommaso Padoa-Schioppa

Member of the Executive Board of the European Central Bank

at the London School of Economics, Financial Markets Group

on 24 February 1999

TABLE OF CONTENTS

I. Introduction

II. Institutional framework

III. Industry scenario

IV. Current supervision

V. Crisis management

VI. Conclusion

Tables

I. INTRODUCTION

1. I am speaking here, at the London School of Economics, only a few

weeks after one of the most remarkable events in the history of monetary

systems: the establishment of a single currency and a single central

banking competence for a group of countries which retain their sovereignty

in many of the key fields where the State exerts its power. To mint or

print the currency, to manage it and to provide the ultimate foundation of

the public's confidence in it has been, from the earliest times, a key

prerogative of the sovereign. "Sovereign" is indeed the name that was given

in the past to one currency. And a British Prime Minister not so long ago

explained her opposition to the idea of the single currency with the desire

to preserve the image of the Queen on the banknotes.

2. For centuries money has had two anchors: a commodity, usually

gold; and the sovereign, i.e. the political power. Less than 30 years after

the last bond to gold was severed (August 1971), the second anchor has also

now been abandoned. Although I personally think that political union in

Europe is desirable, I am aware that the present situation, in which the

area of the single currency is not a politically united one, is likely to

persist for a number of years. This means that we have given rise to an

entirely new type of monetary order. For the people, the success of this

move will ultimately depend on the ability of governments and political

forces to build a political union. For the central banker and for the users

of the new currency, the success will be measured by the quality of the

currency itself, and such quality will be measured in the first place in

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

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