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 Principles of Banking Supervision.
The country-specific, non-harmonised, part of the platform is also quite relevant and very diversified. It includes, among other things, the different organisational arrangements for the conduct of banking supervision (central bank, separate agency or a mixed arrangement); the tools used by banking supervisors (e.g. supervisory reporting, on-site inspections); provisions for the liquidation and restructuring of banks; and the definition and legal protection of financial instruments and contracts. Even the key notion of a regulated market is harmonised only to a very limited extent.
15. Such "neutrality" and "incompleteness" on the part of the EU legislator with respect to key aspects that are normally incorporated in the regulatory framework is a unique feature of EU banking regulations and is likely to trigger a deregulatory process, pushed by competition among the national systems and the different financial centres in the euro area, and beyond that in the EU. Against the background of the increasing competition and other changes in the banking industry, one can expect that the regulatory platform will evolve in the years to come. Additional EU legislation may prove necessary to complete and strengthen the harmonised part. One important part of common legislation, namely the draft Directive on liquidation and re-organisation measures for credit institutions, has not yet been adopted and, indeed, has been stalled for years. This Directive is needed to bring legal certainty to the framework for banking crisis management. In this regard, it would be useful for the Eurosystem, if necessary, to be able to exclude counterparties from the single monetary policy on prudential grounds. Also, the non-harmonised part of the platform will come under pressure to converge, as I have just mentioned, through the process of "regulatory competition". Like any other rapidly changing industry, the banking sector will require careful attention by regulators. As indicated earlier, the ECB will have the possibility of contributing to the rule-making process through its advisory tasks under Article 105 (4) of the Treaty and Article 25.1 of the Statute of the ESCB.
16. On the whole, and taking a euro area perspective, the legislative-cum-regulatory platform of the banking industry, although rather unusual and very diversified in comparison with those of most currency jurisdictions, does not seem to present loopholes or inconsistencies that may hamper the pursuit of systemic stability. Seen from the point of view of the regulatory burden, it is a light system. It will become even more so if competition among national banking systems and financial centres encourages national regulators to free their banks from regulatory burdens that are not required by the EU Directives. Conversely, seen from the point of view of its flexibility, i.e. how quickly it can adapt to new situations, it is, on the contrary, a heavy system. This is the case both because the EU legislative process is slow (three years or even longer may be needed to pass Directives) and, perhaps more importantly, because many provisions are embodied in the Community primary legislation (i.e. Directives) rather than in Community secondary legislation (amendable through simpler comitology procedures).
The establishment of EMU does not seem to determine a need for revising the pillars of the current legal framework. What seems to be necessary, however, is a more flexible legislative procedure which allows for a faster and more effective revision of Community legislation, whenever needed in relation to market developments.
17. Let me now turn to the execution of banking supervision. It should immediately be recalled that supervision, contrary to regulation, is a national task, exercised by what the jargon of the Directives calls the "competent authority". Since the euro area has adopted a separation approach between supervisory and central banking functions, it is natural to examine first the functioning of the "euro area supervisor" (i.e. the co-operative system of national supervisors) and then turn to the tasks and needs of the "euro area central banker" (i.e. the Eurosystem).
18. The euro area supervisor can be regarded as a rather peculiar entity composed of national agencies working in three modes: stand-alone, bilateral and multilateral. Let us briefly examine each of them.
The stand-alone mode is the one in which the supervisor exclusively operates in the national (or even local) context. Today it is by far the most predominant mode. In most cases, this approach is sufficient to achieve the objectives of banking supervision because most banks in Europe are operating in a context that does not even reach the nationwide market of the country of origin. Such a decentralised model is even more effective because it allows the efficient use of information that may not be available far from the market in which the bank operates. That is why it is actually applied even within countries. In Italy, for example, over 600 of the 900 licensed credit institutions at end-1998 were entirely supervised by the Banca d'Italia branch of the town in which the bank is licensed.
The bilateral mode involves co-operation between two supervisory agencies. It is used for cross-border supervision of the same type of financial institutions, such as credit institutions, or the supervision of different types of financial institutions operating in the same market, such as credit institutions and securities firms. The instrument that has been devised to organise bilateral co-operation between banking supervisors is the Memorandum of Understanding (MoU). With the implementation of the 2nd Banking Co-ordination Directive, the Member States began to negotiate extensively MoUs in order to establish the necessary co-operation between "home" and "host country" authorities to supervise efficiently institutions that have cross-border activities or foreign country establishments.
By the end of 1997, 78 bilateral MoUs had been signed between the EEA banking supervisory authorities. The key aims of MoUs are to establish a regular exchange of information between national supervisory authorities. While the "gateways" for the exchange of information have been laid down in Community legislation, MoUs provide a practical framework for communication to be carried out between supervisors. Moreover, MoUs define procedures and reciprocal commitments between pairs of EU supervisors related to the various parts of the supervisory process, such as establishment procedures and on-site examinations.