THE IMPLICATIONS OF ECONOMIC AND MONETARY UNION IN SUSTAINING EUROPEAN MONEY MARKET INTEGRATION

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1 THE IMPLICATIONS OF ECONOMIC AND MONETARY UNION IN SUSTAINING EUROPEAN MONEY MARKET INTEGRATION AVADANEI ANDREEA Alexandru Ioan Cuza University-Iasi ABSTRACT The first ten years of the Economic and Monetary Union have generated a remarkable increase in financial integration, even if the extent of convergence varies across different sectors within the overall European financial system. The scope of this article is to illustrate the general issues relevant for understanding European financial integration by focusing on the money market. The link between the money market and the framework for implementing the single monetary policy makes it the natural starting point when trying to point out the impact of the introduction of the common currency on European financial market integration. Among the various segments of the euro money market, the inter-bank unsecured deposit market has achieved the highest degree of integration and, since the start of Stage Three of EMU, has performed an important role in ensuring the smooth redistribution of liquidity among euro area credit institutions irrespective of their geographical location. The 2007/2008 turmoil has led to increased segmentation in the euro area money market. The assessment of the state of financial integration for the last period is made very difficult by the effects of the financial dislocations on rates and spreads across the different instruments and maturities of the money market. However, the integration and standardization of the money market are not yet complete, and further evolution can be expected. KEY WORDS Money market, monetary policy, financial turmoil, EONIA, common currency 1. Introduction The elimination of multiple currencies, represented by the creation of the European Monetary Union, marks the fall of an important barrier against financial integration. Money and bond market integration was an immediate consequence EMU. The introduction of the euro and the intercept of the single monetary policy on January 1, 1999, accelerated the pace of change. Before Monetary Union, much curiosity and different points of view surrounded the effect of euro adoption on the financial markets. As regards the money market, attention focused, in particular, on questions such as how smoothly the money market would integrate after the start of Stage Three of EMU, whether money markets would perform their role efficiently in the monetary policy transmission process, and to what extent EMU would affect the efficiency of this market compared with that of the predecessor money markets. At the start of EMU in 1999, the condition of the various money market segments differed greatly with regard to their potential integration, owing to the different nature of the instruments exchanged, as well as the peculiarities regarding market participants and other institutional factors. The gains in terms of integration, efficiency and liquidity achieved in each of the market segments following the introduction of the euro depended on a number of factors such as: the degree of proximity of each market to monetary policy implementation; the structure of the market(i.e. mainly inter-bank versus a customerorientated structure, centralized versus an over-the counter or non-centralized structure); its relative complexity(i.e. the number and nature of instruments traded and market participants); infrastructural developments and a number of regulatory, institutional and historical features. The aim of this paper is to present an overview of the European money market integration since the introduction of the common currency in January 1999 until the present financial turmoil, in term of evolution and achievements. In examining developments and integration in the most important segments of the euro-zone money market, we focused on three commonly distinguished markets: the market for unsecured deposits where credit institutions exchange short-term liquidity without the guarantee of collateral, the repo market in which market participants exchange short-term liquidity against collateral, and the foreign currency swap market. We will also look at the derivatives market and the markets for short-term securities. Monitoring the integration of euro area money markets is important for a number of reasons. First, this market is central to the implementation of the single monetary policy of the euro area, since it constitutes the first step in the transmission mechanism of the monetary policy. The monetary market is regularly used by the Eurosystem to distribute liquidity to the market. For example, repo transactions are one of the main instruments used for the Eurosystem s regular refinancing operations. The 1

2 integration of these markets is therefore essential to allow a smooth flow of liquidity between markets and across country borders so that liquidity is distributed evenly within the money market. Beyond these considerations, money market integration is important for the efficient allocation of resources in the euro area and for promoting a more efficient pricing of short-term debt in the euro area. The article is structured to answer three research questions: What is the importance of European money market integration for monetary policy? Which was the evolution of the euro-money market integration and which is the actual stage, considering its main segments? What are the possible implications of the crisis on the integration of money market? In order to develop hypotheses on the effect of the EMU on the money markets, the existing literature on the integration of these markets is being reviewed. 2. Literature review An immediate consequence of the adoption of the common currency was an integration of the euro-zone money and bond markets (Adjaouté and Danthine, 2003; Hartmann et al., 2003). A number of studies analyze the degree of European money market integration from various angles. Santillan et al. (2000) investigate the effects of the introduction of the euro in 1999 on euro area bond and money markets; their study concluded that while the unsecured money market segment very quickly became highly integrated, the repo market lagged in this respect. Hartmann et al. (2001) examine intra-day data for unsecured euro area lending rates during a 5-month period and find cross-border rate differentials to be very small. Therefore, they concluded that the unsecured segment of the money market became very highly integrated almost immediately after the introduction of the common currency. Gaspar, Perez-Quiros and Sicilia (2001) document the story of what they called the learning period in the money market. The period is identified with the three weeks after the introduction of the euro. They argue that the introduction of the new operational framework proceeded remarkably smoothly. If one focuses on volatility or cross-bank dispersion in overnight interest rates, the effects found are much smaller that the effects associated with recurring events such as the end of a reserve maintenance period. This finding is all the more surprising because national money markets, before the start of the single monetary policy, displayed important distinctive features. They also look at the dispersion of interest rates across banks. For this purpose, they use the interest rate obtained by the major European banks when they lend funds in the overnight market. In particular, each data point represents the average interest rate charged in that day by each lending bank. The dataset was provided by the European Banking Federation (EBF) and is the one used to compute the time series for Euro Overnight Index Average (EONIA), which is based on data from a panel of more than 50 banks. It is important to emphasize that observations in the EBF database correspond to actual trends. They show that at the very beginning of the single monetary policy, that is, during the first business week of 1999, some banks reporting to the EONIA panel lent at rates above the marginal lending facility. Galati and Tsatsaronis (2001) and Gaspar et al. (2003) reported that the percentage of cross-border inter-bank lending increased considerably around the time of euro s introduction, indicating a strengthening of the degree of integration in this segment. Focusing on inter-country differences, Baele et al. (2004) document the integration of money markets in the euro area, using the cross-sectional standard deviation of unsecured lending rates, among 12 average country rates and confirm the existence of a well integrated market across countries. Gaspar, Perez-Quiros and Rodriguez-Mendzibal (2004) also look at the cross sectional dispersion of the EONIA overnight rate. They characterize the distribution of rates across contributing banks and study how it evolves over time. As with the money markets, the level of general integration in the longer-term debt securities markets has been impressive. Although spreads are reasonably low in the government bond market, the efficiency and liquidity of that market is constrained by differences in the issuance practices of the member states (Dune et al. (2006), European Commission (2008)). For corporate debt, spreads can be related to sector and firm-level characteristics, with no important role for country-level factors (Baele at al. (2004). In relation to liquidity, Biais et al. (2006), show that the liquidity of euro-denominated bonds is superior to sterling or dollar denominated bonds, which can be attributed to an open and competitive area wide market in which a large number of banks offer dealership services to a wide array of prospective buyers. As is emphasized by Pagano and Von Thadden (2004), the growth in the volume of corporate bond issues can be in part attributed in the euro, in relation to the contribution of the single currency to the increase in competition among underwriters, which led to a substantial reduction in issuance costs and improved access for smaller and higher-risk firms. Still, caution is advised when trying to attribute the progress in integration to the EMU alone. It seems that some significant integration has already taken place prior to EMU, as Hardouvelis, Malliaropulos and Priestly (1999) document. The 2007/2008 financial market turmoil has been discussed extensively in the specialized press (i.e. Financial Times, Wall Street Journal, the Economist), and in social publications (Financial Stability Reviews published by central banks, the IMF and BIS). The academic literature is still in the process of analyzing the 2

3 ongoing events (Ferguson et al. (2007), the articles in Banque de France (2008)). Several dimensions are being explored such as flaws in the pricing models and understanding of credit risk transfer products; the role of securitization, SIVs and off-balance-sheet exposures of banks and their committed credit lines; the role of rating agencies (Ashcraft and Schuermann (2007), Crouhy and Turnbull, (2008), Brunnermeier (2008)); central bank operations and their impact (of lack of) money spreads and volatility (Taylor and Williams, 2008); the role of collateral in open market operations (Ewerhart and Tapking, 2008); and the potential moral hazard implications of recent interventions and innovations in central bank operating procedures (i.e. US Fed and Bank of England s securities swap facilities) (Buiter, 2008). 3. The importance of European money market integration for monetary policy By definition, the start of the Third Stage of EMU had a significant impact on the money market s daily business. The shift in responsibility for monetary policy from the national central banks to the ECB had a clear impact given the banks crucial role in the money market regarding the distribution of liquidity and determining the level of short-term interest rate. The Eurosystem implements monetary policy through the money market. Its operational framework is predicated on a well-functioning monetary market, requiring only a limited presence of the monetary authority. The Eurosystem s operational framework is based on three key elements. First, reserve requirements, with an averaging provision other than reserve maintenance period, allow banks to spread out the impact of liquidity shocks over time and thereby help to contain volatility in overnight interest rates. Required reserves also create a structural liquidity shortage for the banking system as a whole, ensuring that the central bank will be regularly required to supply liquidity to the system. The second key element is standing facilities. The Eurosystem provides two such facilities, a marginal lending facility and a deposit facility. Both are used on the initiative of commercial banks. The two standing facilities define a corridor (or band) for overnight rates (Posen, 2005). The third key element, open market operations, is used to control liquidity conditions in the market. In its regular main refinancing operations, the Eurosystem uses repos, supplying liquidity by buying assets under a repo or granting loans against adequate collateral. Money market integration is therefore crucial for the implementation of the single monetary policy because it provides the locus for the first step in the monetary policy transmission mechanism. During the period from January 4 to 21, 1999 the corridor defined by the two standing facilities was temporarily narrowed to 50 basis points, which limited the volatility that might have been associated with the transition to the new regime. When the corridor was widened to its normal size, the market rate (measured by EONIA rate) remained stable and close to the Eurosystem main refinancing operations rate of 3%. The dispersion of rates across banks was also already much lower on January 22. However, Gaspar, Perez-Quiros and Sicilia (2001) provide evidence showing that the transition was not, strictly speaking, instantaneous and that learning did take place. They identify a number of inefficiencies and other forms of abnormal behavior during the first day of the month- for example, the above mentioned trading at rates significantly higher than the marginal lending facility on January 5. However, they also show that banks have adapted quickly and easily to the new environment. 4. Evolution and achievements of the European money market integration The most immediate and extensive impact of EMU has been felt on the euro-area money markets for unsecured money and derivatives. Almost from the outset of EMU, interest rate on inter-bank deposits and derivative contracts across euro area converged fully to on the benchmark EURIBOR and EONIA rates. This rapid convergence reflected early acceptance of the single monetary policy among market participants and was facilitated by the availability of interconnected systems for real-time settlement of large- value payments in the form of TARGET, which was recently been replaced with a more integrated platform, TARGET2. The successful integration of these unsecured markets was crucial to establishing ECB credibility in the very early period of EMU and has provided the basis for a smooth-functioning single monetary policy thereafter. In this context, the unsecured market became highly liquid and deep, with very big deal sizes, tight bid-ask spreads and equal interest rates at different locations, with the exception of minimal differences, normally well within the bid-ask spreads. The growth of the unsecured segment of the market was concentrated at the shorter maturities, indeed in overnight transactions, which represented by far the largest share of unsecured operations. While the available information for the euro area money markets is scarce on the price side, the EONIA provides a clear indication for overnight developments. The dispersion of the EONIA prevailing among euro area countries has been very small since This is a key development because a common short-term interest rate represents the first step in the transmission mechanism of monetary policy. Between 1999 and 2007, the unsecured segment was highly integrated, with the creation of the euro area lending to a near-complete convergence in key indicators, such as the overnight lending rate. Over the second half of 2007 and the first quarter of 2008, a sharp widening of the dispersion in EONIA lending rates was seen in response to the financial turbulence. This could have been the result of two joint factors-an increase in the variability of counterparty risk and a temporarily higher home bias for 3

4 unsecured transactions (European Commission, 2008). This conclusion is supported by the positive trend in the geographical counterparty breakdown for It appears that over 2007 and the first quarter of 2008 the secured segment has been less influenced by the financial turbulence. Nevertheless some impact has been seen both in terms of reduced cross-border business and increased variability of rates between countries. Outside the euro area, unsecured money market interest rates were also converging up until the emergence of the market turmoil in the latter part of Integration has been less complete in secured money markets within the euro area, such as the market for T- bills, commercial paper and certificates of deposit, as well as the private repo market. The creation of EUREPO index by the European Repo Council and the European Banking Federation in March 2002 was an important recent initiative for promoting the repo market s integration. EUREPO, which was introduced as the benchmark for secured money market transactions in the euro area, is the rate at which one prime bank offers funds in euro to another prime bank in exchange for EUREPO general collateral (GC). The fact that EUREPO GC is clearly and uniquely defined for all market participants facilitates cross-border trades and therefore promotes repo market integration. As far as the integration of these markets is still hindered by the differences in national legal and tax frameworks and by the persistent fragmentation in national clearing and settlement infrastructures that make difficult the cross-border movement of the collateral. However, the implementation of the Financial Collateral Directive (FCD) has reduced the national legal differences and has contributed to the grater usage of cross-border collateral. Although a source of inefficiency, segmentation in these markets was not considered to be a major opportunity cost for the euro area economy so long as the inter-bank market functioned smoothly. However, the liquidity problems experienced in the euro area inter-bank market since august 2007 amid the ongoing international financial turmoil have highlighted the importance of access to efficient collateralized money markets and suggested a need for further effort in integrating these markets. Given the high fragmentation that has characterized the commercial paper market since the introduction of the euro; the harmonization of market standards promoted by the STEP initiative may significantly contribute to the integration of this market segment. Unlike the unsecured and secured segments, the market for short-term securities has shown only limited signs of integration since the introduction of the common currency, mainly because of differences in market practice and standards. An efficient commercial paper (CP) market is needed to ensure the efficient financing for firms and a smooth and timely transmission of monetary policy. Furthermore, the absence of a sufficiently developed CP market may result in elevated and uneven costs of capital in the euro area. Since June 2006, the STEP initiative aims at fostering the integration of this market by promoting convergence of market standards. In 2007, more than half of the outstanding euro-denominated commercial paper has been assigned the STEP label and its share substantially expanded, even in a period of contraction of the entire market (European Commission, 2008). The segment has therefore the potential to become a truly integrated euro area market, of a dimension comparable to that of the US market. Meanwhile, the markets for euro-denominated derivatives have expanded significantly beyond the size implied by legacy currencies, partly reflecting an explosive growth trend in such instruments on a global level, but also the absence of liquidity in underlying cash securities. Interestingly, the vast bulk of activity in eurodenominated derivatives markets takes place outside the euro area in London. Like the unsecured lending market, the euro area interest rate swap rapidly became highly integrated following the introduction of the euro in Price-based measures of integration in the euro area interest rate swap market confirm that this segment indeed already enjoyed a very high degree of integration shortly after the euro s introduction. On the whole, all evidence suggests that the euro area interest rate swap market is not only extremely large and liquid, but also one of the most integrated in the euro area financial landscape. The integration of swaps and future markets is significantly higher than the cash-based markets, reflecting the greater concentration in the derivatives markets among larger, more sophisticated institutions. However, the short-term securities markets are the least integrated component of the money markets: a basic obstacle to a unified short-term securities market has been the diversity in norms and definitions in the design of short-term securities contracts. In respect with the longer-term debt securities, the integration of this market has been impressive. For sovereign debt, spreads across member governments are small relative to the pre-emu patterns and can be related to differences in liquidity properties and credit risk. 5. Main features of the money market in the light of the financial crisis The European money market has been particularly hit by the turmoil. In our view, asymmetric information on credit risk played a crucial role in the transmission of the US sub-prime mortgage market credit shock to this market. Transactions volumes, especially for longer maturities, have declined, and unsecured rates have been characterized by unusually high elevated spreads. As the financial turmoil unfolded, the dispersion of inter-bank lending rates across countries reached unprecedented levels compared with those observed before the crisis began and even in the initial stages of the turmoil in the summer of Moreover, there are indications of emerging differences between domestic and cross-border 4

5 rates in the unsecured money market. In particular, the volumes of cross-border trades declined somewhat compared with domestic transactions. At first glance, this finding seems to indicate a breakdown of the cross-border market with a possible segmentation of money markets across the euro area. The price for these transactions lowered in comparison with domestic trades. Thus, a more likely interpretation seems to be that, as a result of the turmoil, cross-border inter-bank trades are now conducted mainly by banks with a relative high credit standing, who act as money centers in the different countries of the euro area. The higher average quality of cross-country borrowers is reflected in the lower interest rates. Other, most likely smaller or less known banks are mainly trading in domestic markets, where interest are higher, because the average credit risk is perceived to be higher. Thus, in the cross-border context, the events seem to have enforced a two-tier system of the money market, in which smaller banks rely on liquidity provision by internationally active money center banks. During the financial turmoil, the increase in perceived liquidity and credit risks generated a sharp increase of volatility and a decline in trading activity in the euro area market not only for inter-bank unsecured loans but also in segments of the secured non-government repurchase agreements (repo) markets. Many banks no longer accept certain asset types (i.e. ABSs and CDOs) as underlying collateral in repo transactions. Even in those secured money market segments with high quality collateral, turnover has decreased. The reduction in turnover in these markets has two causes. First, because market participants are uncertain about counterparty risk, they have cut their credit lines and reduced their loan volumes markedly. Second, increased uncertainty about their own liquidity needs has led to liquidity hoarding. The dramatic increase in perceived liquidity and credit risks had a major impact on the rates, the volatility and spreads prevailing in the euro area money markets. The cross-sectional standard deviation of the EONIA lending rates across euro area countries clearly signals tensions in the money market. After having reached its lowest level of 1 basis point in 2006, the standard deviation suddenly increased to 4 basis points in mid-2007 before reaching a peak of more than 15 basis points in October 2008 (Lane, 2008). These developments closely followed the different stages of the financial crisis. Increased concerns about the creditworthiness of counterparties and uncertainty about their own liquidity positions prompted banks to hoard liquidity and to lend funds only for the shortest maturities or only against higher-grade collateral in secured markets. In the unsecured segment, liquidity became very scarce at maturities beyond one week, even disappearing at longer maturities. Most inter-bank unsecured lending concentrated on the overnight maturity, but even overnight liquidity remained scarce. The 2007/2008 turmoil has led to increased segmentation in the euro area money market (Cassola, 2008). Asymmetric information problems have been a central feature of the malfunctioning of the money markets. This has led to a two-tier market structure, with the larger banks possessing the highest credit standing active in the cross-border money markets whereas smaller banks are confined to trading with domestic counter-parties. The segmentation is reflected in pricing data, with interest rates on cross-border inter-bank lending lower than on domestic inter-bank lending. As the money markets return to more normal conditions, we may expect the degree of segmentation to decline even if it does not fully return to the pre-turmoil levels. 6. Conclusion Responding to the introduction of the euro and the monetary framework, the money market has undergone a process of deep integration and standardization throughout the euro area. Nevertheless, the degree of integration achieved o date differs among the various market segments. Those which are more integrated are the unsecured deposit market, in which banks exchange shortterm liquidity without the guarantee of collateral, and the derivatives markets. Relatively less integrated segments of the market include the repo market, in which participants exchange short-term liquidity against collateral, and the short-term securities markets (Treasury bills, commercial paper and certificates of deposit). Recent developments suggest that the turmoil is having a significant impact on euro area financial integration in certain sectors: most notably, in the unsecured inter-bank market and in the government bond markets. 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