Ensuring Financial Stability in the Euro Area

AuthorAlessandro Prati and Garry J. Schinasi
PositionEconomist in the Capital Markets and Financial Studies Division of the IMF's Research Department/Chief of the Capital Markets and Financial Studies Division of the IMF's Research Department

    The introduction of the euro is expected to spur the creation of pan-European financial institutions and markets, with considerable benefits for consumers and investors. Challenges remain within the euro area institutional framework for the management of systemic risk and financial crises.

Ensuring financial stability within the European Economic and Monetary Union (EMU) will be challenging in the early years, in part because there are a number of aspects of EMU that might increase the potential for systemic events. First, there is the possibility that TARGET (the Trans-European Automated Real-Time Gross Settlement Express Transfer system)-the settlement system slated to take effect on January 1, 1999 that will link the real-time gross settlement systems of European Union countries-will be used less extensively than expected and might therefore not reduce systemic risk as much as has been anticipated. Second, as new pan-European financial markets emerge, the growth of cross-border unsecured interbank lending could increase the risk of contagion, at least until an EMU-wide repo (repurchase agreement) market is created and use of secured (collateralized) interbank credit lines becomes more widespread. Third, the introduction of the euro is likely to encourage further bank restructuring and consolidation, but in an environment where it may be difficult to close banks and to reduce costs through downsizing. Inefficient and unprofitable institutions may therefore continue to operate, engaging in increasingly risky activities.

Box 1: Prudential supervision and financial stability

The European System of Central Banks Statute and the Maastricht Treaty assign to the European System of Central Banks only limited functions related to prudential supervision and the stability of the financial system, but it does have an explicit role in promoting the smooth functioning of the payment system. The flow of supervisory information between the ECB and the competent authorities is also regulated by the BCCI Directive (Directive 96/25/EC of June 29, 1995).

The European Monetary Institute's 1997 annual report provided some clarification on how these provisions will be implemented in EMU. In EU legislation relating to prudential supervision of credit institutions and the stability of the financial system, the ECB has the option of playing an advisory role and must be consulted only on draft EU and national legislation that influences the stability of financial institutions and markets.

To ensure effective interaction between the European System of Central Banks and national supervisory authorities, the Maastricht Treaty stipulates that the European System of Central Banks "shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system." The European System of Central Banks will not systematically receive supervisory information; its requests for such information will be considered by national banking supervisors, who will inform it, on a case-by-case basis, in the event of a banking crisis with systemic implications. The EU Council of Ministers, upon the initiative of the European Commission, may assign specific tasks to the ECB related to prudential supervision; however, the European Monetary Institute's annual report indicates that any transfer of supervisory powers from national authorities to the central bank is considered premature at this stage.

The possibility of heightened systemic risk may not be apparent in the early days of EMU because market integration and bank restructuring may occur slowly. The limited number of cross-border mergers of European banks that have taken place thus far, the gradual increase of competitive pressures in the retail sector, widespread public ownership of banks, and the underdeveloped state of capital markets in many EMU countries may provide some EMU countries with more time for restructuring banking systems. Decentralized arrangements for market surveillance and crisis management (based on home country supervision, for example) may be...

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