Analytics, EU – Baltic States, Financial Services, Modern EU

Senior fellow at Brussels-based think tank Bruegel and visiting fellow at the Peterson Institute for International Economics in Washington DC, Nicolas Véron is a well-known expert in financial issues. Hence it is important to see his reflections on vital issues in modern financial systems and financial reform around the world, including global financial regulatory initiatives and current developments in the EU. He also touches in a recent publication on key trends in global cross-border finance, on transatlantic capital flows and regulations, as well as on the challenges the Chinese economy’s integration brings into the global system.

Various issues dealt with in Véron’s interview seem well worth to get through. See more in: http://www.iflr.com/Article/3588569/Challenges-to-integration.html

Sub-regions in global finances

It is quite natural that key global trends in cross-border finance occur in economically most active sub-regions, argued Nicolas Véron. For example, significant financial fragmentation existed before 2012-13 in the EU’s eurozone states (with presently 19 entities). Then several regulatory measures were introduced: banking union, capital market union, European Semester, etc. which seriously changed the situation for the better.  

However, from a global perspective, especially in emerging markets, cross-border financial integration has continued more or less on the pre-crisis trend, Nicolas Véron notices. Therefore, he argued, the EU’s efforts to change could be regarded as exclusion rather than an indication of “a change in the global trend towards cross-border financial integration”.

Differences in finances/banks’ roles in creating growth are different in the world: for example, approaches in financing economy in the EU financial system is heavily “bank-based” contrary to, e.g. venture-type investment in the US; the latter proved to be more efficient and resilient.

Therefore, since the crisis the European banks felt pressure from two sides: government’s guarantees and the need to operate in the “lending country” (as, according to Th. Huertas, “banks are international in life, but national in death”).

Note: Dr. Tom Huertas a former member of the Financial Services Authority’s Executive Committee; also served as alternate chair of the European Banking Authority, a member of the Basel Committee on Banking Supervision and a member of the Resolution Steering Committee at the Financial Stability Board.

https://www.ceps.eu/system/files/TFR%20Bank%20Resolution.pdf

EU’s financial “supervision”& global capital flows

In the EU, there are two “actors” dealing with the financial sector: ECB performs supervisory functions under the new banking union regime in 19 eurozone member states and the national banking sectors in the rest of the EU. In the eurozone, there are, in fact a “hybrid EU-member states’ system”.

In fact, there isn’t such an entity as “global financial cycles”; all regions in the world explore their own “cycles”. For example, the US resolved its financial sector problems much more quickly than the EU did, and so did the UK compared to the eurozone states, argued Mr. Véron.

Thus, the global derivatives market has been highly differentiated; these reforms are fully in place only in the US.

As to Asian and other emerging economies, financial instability was not a threat after the crisis, though some economic and trade problems did occur in these regions.  

There are, e.g. some new features in the process: a) concentration of risk in clearinghouses, which are becoming systemically critical to financial institutions; b) the lack of global supervision makes clearinghouses to develop their own supervision and crisis management. Both are challenging the very notion of a globally integrated derivatives market.

Mr. Véron underlined that supervision was to be conducted on a country-by-country basis though the EU doesn't yet work as a single jurisdiction in this area. Therefore a fundamental tension exists between the central clearing mandate and the global integration of OTC derivative markets.

Vital to mention, many people who made financial decisions before the crisis are still in charge and it’s very hard for them to acknowledge that they had not properly considered the consequences when they made their decisions, argued Mr. Véron.

Transatlantic financial issues

Until recently, the Union’s capital market union (CMU) has been a very compelling rhetorical vision proposed by the European Commission, and largely inspired by the UK. But CMU has little to show in terms of actual policy decisions, i.e. largely because of the UK. This is because a credible CMU requires European enforcement of capital markets rules, and the UK didn't want to even consider such options as they viewed Brussels as a power grab on the UK’s leading financial center. However, the UK’s decision to leave the EU will not kill CMU but would make some changes in the decision-making.  

The EU leaders see the CMU as a very positive integration; now when the UK is out the CMU’s “full implementation” might go smoothly without the UK’s structural prevention (largely because of the UK veto against any institutional centralisation in this area).

Note: In 2015, the government deficit and debt of both the euro area (EA19) and the EU28 decreased in relative terms compared with 2014. In the euro area the government deficit to GDP ratio fell from 2.6% in 2014 to 2.1% in 2015, and in the EU28 from 3.0% to 2.4%. In the euro area the government debt to GDP ratio declined from 92.0% at the end of 2014 to 90.4% at the end of 2015, and in the EU28 from 86.7% to 85.0%.

Full text available on EUROSTAT website:

http://europa.eu/rapid/press-release_STAT-16-3498_en.htm?locale=en

The EU-27 is forced however to move towards better integrated and more developed capital markets with additional control over the banks. Most cross-border capital flows are channeled through global banks. It's only natural that most market participants equate more regulation with being bad for business, but this is just not the full story. There's good regulation, and bad regulation, i.e. smart regulation, and dumb regulation. With the deregulation only, the public oversight of financial markets becomes ineffective or powerless; hence ultimately a bad outcome for markets.

Markets need strong policy frameworks: they don't exist in a vacuum. So a structured and effective framework of public policy and governance is needed for markets to thrive. One would have hoped that after 2008, the naïve and misleading view that less regulation is always better for business would have lost traction. But many people have short memories.

Besides, it is a complicated issue to regulate cross border finance: there's always so much change in the financial world. Regulation has to change accordingly, and there's never really a perfect regulatory scheme nor a steady system. Thus regulations have to constantly adapt to new realities. 

Brexit impact on cross-border finances

Presently Brexit makes a lot of uncertainty about getting out of the EU’s connection. UK’s future steps might be clearer as soon as the country and the EU decide the UK-single market issues.  Here the financial services are important as well: if the UK stays in the single market, the whole Brexit issue doesn't change much. But if the UK does leave the single market, then the City will experience huge problems: “leaving the single market will be extremely bad news for the City of London”, argued the expert.

It would mean, for example, that a lot of businesses would be sold to foreign partners or other jurisdictions; some would go to the US, others would probably remain in the same business connections but on different terms inside the EU.

For the US financial sector there are pluses and minuses: in the former it may gain some of the global business presently being done in London; in the latter, there are transition costs to relocating from London to the US. Besides, the US financial sector can adapt easily: for them, the UK has been a great place to do business in the past 20 years, but there's nothing that forces them to stay there if London loses its comparative advantage. And outside of the EU single market, London will certainly lose a lot of its competitive edge.

The problem is that globally, capital markets are not in fact “liberated” or unfettered: there are obvious regulatory challenges, including some effective structures but it is still difficult to have deeply integrated cross-border systems that are also properly regulated. There has been some progress: e.g. the Financial Stability Board (FSB) has made a positive difference. The Basel Committee now monitors how its standards are implemented, etc.

Currently, there is a “hybrid model” where most global regulations are applied inside national jurisdictions. This creates mismatches with the notion of global cross border financial integration. In the European content, Brexit is a loss but the Banking Union is a huge gain.

In other jurisdictions, e.g. China is gradually integrating into a functioning global system: China is already a member of FSB and the Basel Committee. However, it remains largely a financial island, not just for historical reasons but also for structurally. But the country will make a massive presence in global finance, which would create increasingly real challenges in terms of global financial stability.

Another big theme is that, before the crisis, the EU was a big champion of global financial standards. There is still much talk, but the European Commission is definitely in favour of global standards (but the EU has the worst compliance record with Basel III in the world). 

There are also fundamental questions about the analytical lessons of the crisis for cross-border financial integration. There is surprisingly little good literature on the trade-offs of cross-border financial integration for advanced economies, as opposed to developing countries. The reason is the conventional wisdom which implies that for developed economies cross-border finance is always good. However, during last decade there are second thoughts: complex relationships between financial openness, financial development and financial stability require a lot more research than there has been so far, including better financial statistics; there is progress, but it is slow.

It's actually easy to underestimate the benefits of cross-border financial integration, including in terms of financial stability. For example, everyone knows about German banks being hit by US subprime losses in 2007 and that's clearly an instance in which cross-border finance propagates financial instability. But think of what happened in Eastern Europe, and in the Baltics in particular, where the financial system being foreign-owned was actually a big stabilising factor in a domestic boom and bust cycle, poses question the expert.

Nicolas Véron, a senior fellow at Brussels-based think tank Bruegel and visiting fellow at the Peterson Institute for International Economics in Washington DC.  

Source: http://www.iflr.com/Article/3588569/Challenges-to-integration.html.