The Euro and the Single Market in Financial Services

Speech by Chris Huhne MEP delivered to the Euromoney Commercial Paper conference on Wed 15th May 2002

Market professionals are usually the best people to spot a short term trend, and are some of the least interested people in a long term one. But I hope that the trends that affect the business of the financial markets themselves are an exception. And into this category, the Euro is the single biggest trend-bender for a very long time. The Euro is in the process of reshaping the very nature of the financial system in Europe, cutting out the traditional banking middle man. We are shifting the broad structure from a universal or retail-bank based system to an American-style financial system characterised by much larger equity and bond markets.

The short term cycle - the bear market, the downturn in Mergers and Acquisitions, the sackings - obscures the underlying trend. But the trend is unmistakable, and if it continues it will gradually transform the financial environment for European securities firms whether brokers, investment bankers or rating agencies.

The Euro denominated corporate debt market is exploding: up from outstandings of €476 billion at the end of 1998 to €1.2 trillion at the end of 2001. That is a spectacular increase of 156 per cent, a near doubling in the share of non-bank corporates in the total up to 15 per cent. We now have a real corporate bond market, able to raise serious finance in spectacularly short periods of time.

What is more, there was a new record last year. The private sector now accounts for more than half of all euro-area bond outstandings for the first time in living memory. The equity market has also expanded, disregarding the recent lull. There are more share listings. More volume.

The reason for this historic shift is the Euro. The end of national currency segmentation in twelve countries. Until 1 January 1999, investors in an EU member state could invest only a small amount outside their domestic currency, since they were bound either by prudential practice or by regulation into largely matching their currency assets and liabilities. Hence a typical Belgian insurer would be constrained to maintain the portfolio overwhelmingly in Belgian francs. For the fixed interest part of the portfolio, that effectively meant government debt simply because of the lack of availability of an array of corporate debt. Unable to put together portfolios, investors proved to be averse to relatively risky individual securities.

The new ability to range widely over the whole euro-area without taking currency risk has transformed the investor appetite for particular securities. We now have a corporate debt market, and within that total we now have a high yield corporate market. On the equity side, the equity culture had already been growing in Frankfurt and Paris: share listings are up 49 per cent and up 47 per cent respectively over ten years. And equity volumes have been growing. Securities markets are still a far cheaper alternative for most companies than borrowing from the banks, with all their overheads. Cutting out the banks - disintermediation - is as attractive as ever. The question is how far and how fast this trend can go on.

My own view is that the best is still to come. Just look, for example, at the volume of share trading in New York at nearly £21 trillion a year compared with just £7.2 trillion if you add London, Paris and Frankfurt together. If the Euro-area financial markets gradually grow to resemble those of New York - in depth, liquidity, size - the potential gains for the securities markets over the next few years are enormous. They could literally treble in size. If they were to do so, they would generate additional commission income across Europe of some £14 billion.

But we need more than the Euro, of course. The Euro is a necessary condition for the explosive disintermediation that we have seen, because of the portfolio effect. But there are many obstacles still to an effective functioning of a single market in securities, let alone retail financial services. Together, these obstacles could deprive the markets of much of their potential growth. They could stifle competition. They could continue to ensure that European investors pay seven times as much in clearing and settlement as Americans.

Even in the wholesale markets, there are considerable problems that need to be addressed. The agreement between the Commission and the European Parliament has now unlocked the fast-track procedures proposed by Baron Lamfalussy and his group of wise men. My guess is that, as a result, we will reach the goal of passing the securities market legislation in the Financial Services Action Plan by the end of this year.

That means agreement on prospectuses, market abuse, capital for financial conglomerates and occupational pensions. And the remainder - with some of the most difficult retail issues - by 2005. It is a tight timetable. But it is achievable with good will.

After all, 25 of the 42 original measures in the FSAP have already been passed. And for what remains, the real question is not timing, but the quality of the legislation. We must not get directives and regulations onto the statute book just to fill the Commission's quota. They have to be real market opening measures that allow competition to work. There is no point in passing measures that simply lock in bad national practices. We do not need a Common Agricultural Policy for financial services. But if quality is to be maintained, market professionals have to take a closer interest in the process. The EU - in the FSAP but also in Basel 2 - is the regulator for the Euromarkets. We must get it right. And we need your help to do so.

For me, there are some clear litmus tests. The supplementary pensions directive must allow fund managers the flexibility to manage portfolios prudently: a fund full of fifty-somethings should be overweight with bonds, a fund for a young workforce should be overweight with equities. But any attempt to impose quantitative rules would fly in the face of the experience in all the countries with a proper level of private provision, including Britain, Ireland, Denmark and the Netherlands. The Council of Ministers should take time to get this right, rather than rush through a botched job that wrecks investor returns in countries with privately provided pensions.

Similarly, the prospectus directive must allow issuers to go to investors in everyone of the 15 member states with only one national approval. National regulators should not be able - as the French and Spanish now do - to insist on full translation into the national language, as that adds €100,000 for each 70 pages of legally approved text. The Parliament's solution to a regulator's attempt to impose unreasonable demands is to allow an issuer to go to another regulator. Neither the Commission nor the Council have yet come up with a rival solution that will tame the over-zealous.

Moreover, disclosure procedures must be appropriate both to the type of issuer - for example, allowing the AIM market for small quoted companies to continue with its NOMAD system - but also to the type of investors. We must make sure that the wholesale market is not penalised. And we must end the cheeky suggestion of the Commission and the EU governments that they should be excused from the requirements of their own prospectus directive. As Lord Denning used to remark, nobody is so high that they should be above the law.

Perhaps the most difficult area will be a new takeover directive establishing rules to protect minority investors, and by prohibiting poison pills without shareholder agreement. The previous draft was lost after twelve years of negotiation in a tied vote in the European Parliament last year. There was a robust German campaign against the possibility of more hostile takeovers. Let us hope that the September general election in Germany will ease the sensitivities on this issue, but it is striking how reluctant Germany has been to accept foreign capital running its businesses.

Vodafone's takeover of Mannesmann was literally a first. Contrast, in the financial sector, the 55 per cent of all UK banking assets accounted for by foreign banks. In Germany, the foreign banks' figure is just 6.5 per cent of the total. Britain, ironically, already passes the openness test when it comes to foreign investors. We may have political hang-ups about Europe, but we have none about continental companies. The same cannot yet be said for all the Euro-area countries, or even for the biggest one.

Yet cross-border mergers are an essential part of the restructuring to take full advantage of the Euro. No-one is particularly in favour of hostile takeovers - after all, the evidence suggests that they are even bad for the bidders' shareholders - but the possibility of a hostile takeover changes the balance of negotiation in many other cases. Block hostile bids, and agreed mergers will become more difficult. And without agreed mergers and restructuring, Europe will not attain America's economies of scale.

Of course, we must also learn from America's successes and failures. We need International Accounting Standards, and they are now agreed by the EU. We need common standards on regular reporting, and we need in my view to look long and hard at the lessons of Enron. Enron was not a one-off: in the United States, Global Crossing and Waste Management both showed similar audit problems. Here, many investors are unhappy with the reporting of Marconi.

One solution would be to be much stricter on conflicts of interest, so that auditors had more incentive to look to their professional reputation and less to mollycoddle the client. That would mean cutting out consultancy fee income, and perhaps too considering the rotation of auditors. The Canadians already operate such a system, but on a rather too brief cycle of three years. By the time one audit firm has mastered the books, it has to train up another. An alternative has been put forward by US Congressman John Lafalce, the ranking Democrat on the House financial services committee. He has proposed a four year rotation, with a possible renewal for a further four years. If securities markets are to be the repository of investors' savings for retirement and distress, accounts must be as open and transparent as possible.

The Euro has given us an extraordinary opportunity. It is rapidly creating trade between the Euro-area countries: up on average by 3.3 per cent of GDP since the beginning of the system, adding more than a percentage point to their GDP. It is encouraging cross-border investment. It has led to a sharp increase in foreign direct investment between euro-area members, up nearly ninefold since 1996. And it has created the conditions for a single market in financial services. These are real achievements, but the Euro is not a magic wand that solves all problems. The task now is to build on its success with a single market that delivers competition and competitiveness. A single market needs a single currency, but a single currency also needs a single market in financial services.