In its third Report on Financial Integration in Europe, the European Central Bank (ECB) signals that there is a risk that the financial integration process in Europe will slow down as a result of the financial and economic crisis. This year’s report focuses on the impact of the financial crisis on the financial integration process. It notes that while significant progress in European financial integration has been made over a longer period of time, signs of retrenchment within national borders have recently emerged in certain financial market segments.

Financial integration is of key importance for the European Single Market and the ECB. First, it facilitates the smooth implementation of monetary policy and the balanced transmission of its effects throughout the euro area. It also contributes to financial stability by creating larger, more liquid and competitive markets which offer increased possibilities for risk diversification. Finally, financial integration fosters economic growth and welfare because it is beneficial to the further development and efficiency of the financial system. For all these reasons, the ECB considers that vigilance should be exercised to avoid a slowdown, or even reversal, of the financial integration process in Europe.

This year’s report also covers aspects of financial development. Financial integration and financial development are normally complementary and mutually reinforcing: integration fosters financial development by enhancing the competitive stimulus, and financial development helps to overcome frictions and cross-border barriers that prevent full integration. However, the ongoing crisis also shows that financial innovation can at times be implemented in ways that reduce transparency and lead to excessive risk-taking, ultimately harming financial integration. One example of this is the pursuit of certain types of securitisation through the creation of sizeable off-balance sheet structures.

The report consists of three main chapters. The first assesses the state of financial integration in the euro area based on a set of statistical indicators developed by the ECB. The second includes thematic sections (“Special Features”) containing an in-depth assessment of three selected topics.

* The first Special Feature deals with the impact of the financial crisis on euro area financial integration. Some market segments are more affected than others: in unsecured money markets and government bond markets, in particular, liquidity risk and credit risk concerns have increased sharply, notably across borders. Conversely, traditional retail banking business with foreign clients has not been greatly affected so far. Once more stable conditions return and the long-term drivers of financial integration continue to operate, the recent adverse effects of the crisis may be reversed. Nonetheless, vigilance should be exercised to ensure that national emergency measures to address the crisis do not have an unintended negative impact on European financial integration.

* The second Special Feature looks at the role of institutional investors in financial integration. Investment funds, insurance corporations and pension funds make an important contribution to European financial integration through the geographical diversification of their investment portfolios. According to the latest available data (third quarter of 2008) their portfolio allocation strategies across the euro area do not seem to have been greatly affected by the financial crisis as yet, but their overall assets under management have shrunk.

* The third Special Feature deals with the financing of small and medium-sized enterprises and young innovative companies, which make an important contribution to employment and growth in Europe. These companies typically face greater financing constraints and costs than other firms, which may hamper innovation and growth. Access to finance by such companies could be facilitated by improving the structure of credit markets, further developing the European venture capital industry and avoiding distortions in tax or regulatory measures. It is particularly important that sound firms of this type benefit from continued access to cost-effective financing despite the financial turbulence.

The last chapter of the report provides an overview of the main Eurosystem activities in the field of financial integration in 2008.