the Macro-Economic Impact of Integration of EU Financial Markets",
Financial services: integration of EU markets
will boost growth, jobs and prosperity says new research
The integration of EU financial markets will bring
significant benefits to businesses, investors and consumers. New
research predicts that EU-wide real GDP will increase by 1.1%
- or 130 billion in 2002 prices over a decade or so. Total
employment will increase by 0.5%. Businesses will be able to get
cheaper finance: integration of EU equity markets will reduce
the cost of equity capital by 0.5% and a 0.4% decrease in the
cost of corporate bond finance is expected to follow. Investors
will benefit from higher risk-adjusted returns on savings. These
are the main findings of new research conducted for the European
Internal Market Commissioner Frits Bolkestein said:
"This economic evidence confirms what we have always said
- that an integrated capital market in the EU will strengthen
our economy. These results confirm the enormous prize that is
up for grabs if we can finish off what we have started and drive
through the remaining elements of the Financial Services Action
Plan. I will do my utmost to achieve that and call upon the European
Parliament and the Council to do likewise by taking the remaining
difficult decisions that are necessary as quickly as possible.
We must not miss this chance to put money in the pocket of every
European. Furthermore these are the minimum gains they do not
cover other major benefits such as wider choice, more innovation
and easier finance for small companies. There could not be a better
wake-up call to accelerate action.
The study is the first substantive piece of empirical
research on the impact of financial integration on the cost of
raising finance in Europe. The work began in late 2001. The consultants
were invited to evaluate any impact of integrating EU equity and
corporate bond markets on trading costs and the cost of capital.
To the extent that a cost of capital impact could be discerned,
they were asked to quantify any consequent impact on investment,
GDP and employment.
This research highlights the powerful role that efficient
and liquid financial markets can play in complementing bank-based
finance to support growth and employment in Europe. It illustrates
the need to complete the implementation of the EU's Financial
Services Action Plan on schedule by 2005. The swift adoption of
legislative proposals on Prospectuses, Market Abuse and Pension
Funds, which are currently under negotiation in the Parliament
and the Council, would be a decisive step in this direction.
The one measure which will do most to unleash these
benefits will be the forthcoming Directive on investment services
and regulated markets, due to be proposed shortly.
The estimates measure only the static effect of financial
market integration on trading spreads (implicit trading costs).
The research does not consider possible reductions in explicit
trading costs (brokerage commissions or exchange fees) that can
be expected to accompany increased competition between intermediaries
and exchanges and lead to further economic benefits for EU citizens
Furthermore, it does not measure the full dynamic
benefits of financial integration. Related research including
a further study to be published shortly by the Commission suggests
that the deepening of financial markets resulting from integration
can permanently boost output growth in manufacturing industry.
The cost of equity capital would fall, on average
across Europe, by about 40 basis points, as a result of integration
of EU financial markets.
There would be a further reduction of 10 basis points
arising from reduced clearance and settlement costs, implying
a total reduction in the cost of capital of, on average, 50 basis
points across Member States.
The simulations performed as part of the study show
that the combined reduction in the cost of equity, bond and bank
finance, together with the increase in the share of bond finance
in total debt finance should improve the equilibrium level of
GDP and potentially also GDP growth:
- EU-wide real GDP is forecast to rise by 1.1%,
or 130 billion in 2002 prices, in the long-run, defined
as over a decade or so
- GDP per capita in current prices is forecast
to be 600 higher in the EU and GDP per capita at 2002 prices
- total business investment is forecast to be almost
6.0% higher and private consumption up by 0.8%
- total employment is forecast to be 0.5% higher.
These benefits will be shared by all Member States.
There are no losers. Across the EU, the estimated increase in
the level of real GDP stemming from integration of financial markets
ranges from 0.3% to 2.0%. However, the majority of Member States
show an increase in the range of 0.9% to 1.2%.
A breakdown of the contribution of the various changes
in the user cost of capital shows that:
- the reduction in the cost of equity finance is
the most important impact, accounting for 0.5 percentage
points (or 45%) of the 1.1 percentage point increase in the EU- wide
level of GDP in constant prices
the impact of the reduction of 40 basis points in
the cost of bond finance alone is marginal, explaining a further
0.1 percentage point of the 1.1 percentage point increase in the
EU-wide level of GDP in constant prices
The combination of the reduction in the cost of bond
finance together with the increase in the share of bond finance
in total debt finance, however, results in a more substantial
boost to output. Together these two changes account for 0.3 percentage
point of the 1.1 percentage point increase forecast in the EU-wide
level of GDP in constant prices
Finally, the assumed reduction in the cost of bank
finance of 20 basis points also explains 0.3 percentage point
of the 1.1 percentage point increase forecast in EU-wide real
The results of the study do not take account of any
dynamic effects that could raise output and productivity growth
on a permanent basis. Thus, they can be said to be relatively
conservative estimates of the likely impact of reductions in the
user cost of capital brought about by deeper European financial
Moreover, European financial market integration will
affect the EU economies through a number of additional channels
(better portfolio allocations, greater access to finance, more
innovation etc). Thus, the overall impact of European financial
market integration is likely to be larger than reported in the
research, which has focused on only one dimension of this integration
process. A further study, to be published shortly by the Commission,
supports this view by indicating the potential for permanently
higher output growth in the manufacturing sector if all EU firms
were to have access to more integrated and developed financial
The full results are available on the Europa website:
"Benefits of a Working EU Market for Financial
Services", November 2002
In spite of considerable progress toward European
capital market integration following the completion of the Single
Market and the introduction of the Euro, national borders still
constitute a considerable de facto barrier for retail financial
markets. Direct cross-border business between financial service
sup-pliers and end consumers is still the exception. Against this
background this report addresses the following questions:
How powerful is the integrating effect of ongoing
market trends like internet and cross-border mergers and acquisitions?
Which benefits could be realised if a higher level
of integration could be achieved?
Which obstacles are mainly responsible for incomplete
2.Deficits of retail market integration
Although stringent legal impediments to cross-border
activities in banking and insurance no longer exist different
indicators show a relatively low openness of national markets.
The market shares of foreign banks in individual EU countries
are relatively small compared to other wealthy industrial countries.
Entry into national banking markets is largely occurring
through mergers and acquisitions (M&A). Case studies on multinational
banks reveal that factors like high fixed costs of market entry
make greenfield investment less attractive than M&A based
The picture is not very different for the insurance
sector where direct cross-border sales without physical presence
in the target market play only a marginal role. Again, cross-border
M&As are the predominant entry strategy. In addition, integration
indicators show a markedly lower integration level for the life
than for the non-life insurance market.
European fund market data on the number of registered
foreign funds seems to indicate a larger degree of integration.
However, since many of these "foreign" funds are of
the Luxembourg or Dublin "round-trip" type, this indicator
is misleading. Market shares of true foreign funds only reach
significant levels in big markets like Germany while some small
markets are effectively completely dominated by domestic fund
The impact of the internet on the integration of
retail markets for financial services does not meet optimistic
expectations even in the case of the most developed e-finance
market, the market for online brokerage. The analysis of price
differences and direct cross-border activities dispells illusions:
although the internet is increasingly becoming an alternative
distribution channel it does not by itself overcome fragmentation
of retail financial markets in the EU.
The report advances the following arguments and quantified
estimates on the beneficial consequences of further integration
of financial services markets for consumers and the economy in
the EU as a whole:
-Product choice would increase, in particular
for consumers in small countries who today suffer most from incomplete
retail market integration. In these countries, the supply of available
funds for example could be augmented by a factor between 10 and
-There is considerable scope for falling prices resulting
from a higher integration level in financial retail markets. Economies
of scale could be realised. Calculations for the fund industry
indicate a large cost savings potential: on the assumption that
integration would lead to an average fund size in Europe similar
to that of the US, there would be a cost saving potential of
about 5 billion Euro annually given the present size of the
EU fund industry.
These cost savings would be particularly helpful
in the ongoing European reforms of pension systems since fund
products will play an important role for funded old-age pensions.
- Private borrowers could benefit substantially through
lower interest rates. A simulation for the period of falling
interest rates in the second half of the nineties shows: if competitive
pressure in a more closely integrated financial market forced
banks to adjust mortgage interest rates more quickly to falling
market rates private borrowers would benefit. In terms of a 100,000
Euro mortgage loan these integration savings in interest payments
would have amounted in the period 1995-1999 to annually 2,550
Euro in Italy, 1,690 Euro in Spain, 1,580 Euro in Portugal and
790 Euro in Ireland.
- Retail market integration would probably also reduce
the well-known home bias in private investors' portfolios. Performance
calculations for national, European and world portfolios show
that investors could significantly in-crease the Sharpe ratios
of portfolios. Often the Europe-wide diversification is already
sufficient to harvest all the benefits of international diversification.
-Furthermore, a larger degree of financial integration
would be associated with higher economic growth. Theoretical
considerations and insights from the relevant empirical literature
back the assumption of a significant link between financial integration
and growth. World-wide cross-country samples show that differences
in financial integration between countries amounting to one standard
deviation of the relevant integration indicators can explain annual
growth differences of 0.5 - 0.7 per cent. Although these results
do not cover all present EU member states they indicate roughly
the potential for growth through financial integration: in terms
of the EU GDP of the year 2000 the lower per cent figure of 0.5
would mean an additional growth effect of 43 billion Euro annually.
A quantification of potential employment effects associated with
more financial integration is difficult to make. They crucially
depend on the flexibility of labour markets and the progress in
labour market reforms.
-Finally, more financial integration is rewarded
by a growing international role of the Euro because the
efficiency of a currency's financial markets is among the determinants
of its global acceptance. A greater acceptance of the Euro could
in turn lead to additional benefits due to higher seigniorage,
falling liquidity premiums and transaction costs.
A number of obstacles impedes the development of
unified financial retail markets in Europe. There are policy-induced
obstacles like different taxation, consumer protection or supervision
arrangements that are capable of alteration, and there are natural
obstacles like differences in language and culture that can not
realistically be addressed by national or European policymakers.
The impact of the different types of obstacles varies
according to product type.
- For insurance products, a lack of confidence
in the long-run reliability of unknown foreign suppliers is a
particularly relevant obstacle. Furthermore, discriminatory tax
practices and national differences in consumer protection due
to different national policies and interpretations of the "general
good" are important obstacles in the insurance business.
- The internet-based financial retail business
is confronted with the following obstacles in cross-border activities:
the need to design a variety of national marketing strategies,
market peculiarities related to regulatory differences in consumer
protection and supervision, the high costs of cross-border payments,
the problems of cross-border identification of new customers,
the heterogeneity of technical systems of stock exchanges and
the consumer preference for "handshake", the physical
meeting with the agent of a new supplier.
- Since successful management of asymmetric information
problems is crucial for successful credit business, limited
cross-border access to public credit registers and private credit
buraux is a particular integration obstacle for the credit market.
- For funds the outdated definition of UCITS
in the directives limits cross-border marketing of innovative
fund products. In addition, the burden of registration in a target
market raises the costs for entering a national market. Furthermore,
host country responsibility for supervision of advertising and
marketing together with tax discriminations hamper the emergence
of a unified fund market. The problems are aggravated by distribution
channels that are still biased in favour of domestic fund companies.
- There is the danger that new obstacles are created
as a consequence of national pension reforms. The German example
shows that very specific national requirements on new pension
products can constitute additional barriers to entry for foreign
A strategy based on an attitude of "wait and
see" is not justified because on-going market trends indicate
that integration is unlikely to be completed without adjustments
to the regulatory framework. The substantial potential benefits
for consumers and economic growth clearly show that it is worthwhile
to push hard for more integration of retail financial markets.
Any integration strategy should aim to simplify direct cross-border
contact between suppliers and consumers.
This contact would speed up convergence of prices
and promote a wider product choice everywhere in the EU. The need
for political action also comes from the delicate fact that the
"costs of non-Europe" are higher in smaller and poorer
member countries than in the bigger and richer ones. While the
Financial Services Action Plan and other legal initiatives properly
address a number of integration obstacles, more needs to be done.
Proposals for reforms are listed below. This is not an exhaustive
list of recommendations. It briefly addresses the most burning
issues; a detailed specification of the reform options would certainly
need further analysis.
It is important to devote more effort to ending discriminatory
tax practices that currently shelter some national retail
financial markets from foreign competition, and which do not conform
with the EU Treaty. Examples concern the markets for life insurance
and investment funds.
Differences in consumer protection rules among
the 15 EU countries render a pan-European marketing strategy and
standardised products impossible. This issue is a critical policy-induced
obstacle and could best be addressed by the creation of a consistent
uniform level of protection with harmonization on that basis.
Three specific recommendations are:
- The debate on derogation from the principle of
home country control in the e-commerce directive should be reopened.
- Furthermore, the interpretation of the "general
good" provision should be harmonised and/or restricted.
- There is a need to arrive at a unified definition
of pension products in order to improve the conditions for developing
a pan-European market for this high potential market segment.
With FIN-NET the Commission has initiated an important
infrastructure for creating consumer confidence in the
legal safety of cross-border financial services. However, the
existence of FIN-NET so far is not common knowledge.
An information campaign is necessary to make this
network of European ombudsmen better known and better understood,
at least to the financial media and the staff of banks and insurers.
With regard to supervision, there are short-,
medium- and long-term options:
- In the short-run it would be helpful if the supervisory
committees devoted more effort to the consistency of rule-books,
the standardization of reporting requirements and the harmonisation
of supervisory practice.
- In the medium-term a serious reform debate should
be initiated, reflecting the possible advantages of a two tier
supervisory system where multinational companies could opt for
supervision on a European level.
- With a long-term perspective, more thought could
be given to the possibility of establishing a single European
supervisory authority, especially if effective cooperation among
25 to 30 national agencies after enlargement proves to become
There is a huge gap between the vision of
the EU as the most dynamic economy in the world and the reality
of still fragmented EU-markets. In order to reduce this gap,
the whole process of European regulation of financial services
needs to be speeded up and member-states have to over-come their
national policies of preserving market barriers or even re-establishing
new ones. Otherwise it will be impossible to achieve the strategic
objective of the Lisbon-process of a more deeply integrated European
Union which will be able to match the challenges of globalization
and to secure full employment by 2010.
Finally, while the study has shed light on important
aspects of the enduring "cost of non-Europe" further
analysis is required. Two issues deserve to be looked at more
closely given their enormous complexity: First, the implication
of national pension reforms for integration and second, the adjustment
of consumer protection regulation to the changing needs of the
internal financial retail market.
3.Summary of key findings of OC&C Report
"The Potential Impacts of ISD2 Article 25",
Impact of Article 25 as Originally Drafted
1.Given that most Firms provide principal liquidity
to their institutional clients across a broad range of equities,
Article 25 would require them to publish continuous, firm, two-way
prices in retail size for those equities - and to deal at these
2.Article 25 would also appear to require Firms to
deal via these retail-size prices with most "eligible counterparties"
(which are defined by Member States). This implies that Firms
would need to deal with a broader range of counterparties than
they do today, with potential consequent increase to counterparty
3.In broad terms Firms have four options in responding
to this requirement:
(1) Offer competitive retail prices and seek retail
(2) Offer uncompetitive prices so as to avoid having
to execute retail business (though they may be restricted in their
ability to do this on account of the requirement in article 25.3
for prices to reflect 'prevailing market conditions')
(3) Refrain from offering these retail-size prices
and therefore have to withdraw from providing principal liquidity
(in those stocks) to institutional customers
(4) Relocate trading operations outside the EU
Leaving aside the somewhat draconian option 4, and
assuming that option 2 is possible, firms would be expected to
make their decisions based on:
(i) the costs involved in options (1) and (2) (including
increased counterparty risk)
(ii) the revenue likely to be generated under option
(iii) the impact of pulling out of principal, institutional
trading under option (3).
(5) Assessing the likely revenue from option (1)
- and the likely detriment from option (3) - is difficult. However,
it is fairly clear that:
Firms with existing principal retail execution infrastructure
(used at present largely for UK equities) would probably expand
into the principal execution of retail order flow in Continental
European equities with high traded turnover so as to be able to
continue to offer principal execution to institutional clients.
There would thus be an increase in principal trading activity
at the retail level
Firms with or without existing principal retail execution
would be likely to withdraw from principal trading in some less
liquid (i.e., lower turnover) equities at the institutional level
because principal trading at the retail level would be economically
(6) This withdrawal of liquidity at the institutional
level is likely to cause spreads to widen on the affected stocks
(from 5bp to 50bp depending on underlying liquidity). We estimate
that this widening might cost European institutional investors
around £200m per annum (about EUR300m) in worse
prices, or simply discourage trading per se. The widening of spreads
would be most notable at the smaller exchanges that might dent
their ability to compete. The magnitude of this impact is very
much determined by the scope of the stocks affected by the regulations.
(7) Total withdrawal of principal liquidity by Firms
in the lowest traded stocks would expose institutional investors
to increased market impact that might cause a further detriment
of c £50m (about EUR 75m) per annum.
Neither this, nor the effect set out in para -6 above, is a desirable
(8) Retail investors would also get worse prices
under these new arrangements in that Firms would be reluctant
to publish prices which included "price improvement"
(as is currently the practice) for fear of being exposed to uncontrollable
volumes and unwanted counterparties. This effect would cost retail
investors an average 10% worsening of spreads.
Impact of Recent Compromise Proposals
(9) Recent (mid-July) compromise proposals seem to
embody three major changes: (1) limiting the scope of Article
25's pre-trade price transparency requirements to Firms who "internalize
on a systematic, regular and continuous basis", (2) expanding
the scope of securities covered to "all listed securities"
and (3) moving the published price requirement to "normal/standard
market size". At the same time there is still debate around
(i) whether to allow Firms to be more selective in their choice
of counterparty and (ii) whether to allow Firms the ability to
"price improve" their quotes on a client-by-client basis.
(10) While the narrowing of scope to the most active/systematic
providers of principal execution appears a welcome step, the shift
to normal/standard market size would move the impact of Article
25 directly onto the (core) institutional market. Without the
ability to choose counterparties or the ability to price improve,
those Firms who are caught by this provision will probably find
it unattractive to continue to provide principal liquidity, This
loss of liquidity would cause deterioration of prices for institutional
clients (which might be worth EUR 375- 450m (around £300m)
per annum and loss of price immediacy.
(11) Of all the provisions, the ability to price
improve is probably the most important one as it provides the
safety valve that would allow the other requirements to be workable.
The True Extent of Off-Exchange Trading
(12) The ISD2 legislation appears predicated on the
assumption that off-exchange trading (internalisation) is both
significant and detrimental. Our findings suggest that there is
much confusion surrounding the definition of terms and that, in
reality, 'true' off-exchange activity is neither overly large
(13) We have developed a framework for identifying
the various different routes for the execution of client orders
in the context of order-book equities and classifying them as
on- versus off- exchange.
Based on indicative data from Firms, the key findings
for order-driven stocks across Europe are:
- Pure agency trading is little used (4% of total
traded value); instead major use is made of back-to-back risk-less
principal trading (47%) which achieves the same end result and
should be treated as on-exchange trading
- Extensive use is made of "worked risk-less
principal trades" (23%) whereby the Firm smoothes the order
into the market over time. Again we consider these to be on-exchange
- The remaining 26% of client trades is handled
by Firms as "true principal trades" i.e., where the
Firm provides liquidity and price immediacy for its clients. However
around half of the resulting positions are actually still worked-off
in central markets. Hence the only truly off-exchange trading
is the circa 10% which the Firm 'crosses' between clients and
the circa 4% which the Firm executes directly with other Firms
(inter-investment firm market)
(14) We therefore conclude that off-exchange trading
is rather less than some other data would lead one to believe.
Consequently, the extent to which principal trading of equities
by Firms 'fragments' liquidity is probably less than generally
The Economic Rationale for Firms to Undertake
Principal Trading at both Institutional and Retail Levels
(15) Although still a widely debated issue, OC&C's
view is that the 'fragmentation' of liquidity between different
trading venues does not necessarily mean that overall market liquidity
is diminished provided that there are some (investor) firms who
can access across the different pools of liquidity. Rather, we
would argue that principal trading by Firms is economically advantageous
for certain kinds of orders (essentially very small orders and
very large orders) with the result that overall liquidity is enhanced.
(16) Principal trading by Firms for large institutional
orders offers advantages in that it can (i) mitigate "market
impact" by "smoothing out" demand on the central
market which helps avoid unnecessary price volatility (worth potentially
30-50bp), (ii) reduce transaction costs (given the lower cost
involved in crossed trades) and (iii) provide price immediacy
(which stimulates trading).
Given active competition between Firms, these benefits
will largely accrue to investors.
(17) Principal trading at the level of retail order
flow is also economically advantageous in that principal execution
is inherently cheaper on account of (i) reduction in exchange
fees and market-side clearing and settlement costs as the Firm
only needs to go to the market (to flatten the net position) on
a periodic basis; (ii) ability for Firm to capture spread through
crossing of trades which allows the Firm to reduce/eliminate commission;
(iii) potentially reduced clearing and settlement costs on the
client-side as and when custody is shared.
(18) Finally, it is hard to argue that principal
trading by Firms causes detriment to investors through lack of
price transparency as (i) institutional investors are sophisticated
and (ii) retail investors (trading via retail-facing intermediaries)
are generally protected by best execution rules.
(19) Overall, the model whereby Firms "smooth
out" large institutional orders at one end of the order size
spectrum and "aggregate" small, retail orders at the
other end of the size spectrum is economically sound. Most of
this apparently off-exchange trading activity does in fact end
up in the central market as the potential for off-exchange crossing
is actually quite limited.
(20) While the intentions seem honourable, many of
the ISD2 proposals appear to be misguided in that they may well
cause a withdrawal of liquidity from these principal trading roles
which will increase costs and hurt investors through reduced liquidity,
increased volatility and spreads, and worse prices.