Select Committee on European Union Forty-Fifth Report



"Quantification of the Macro-Economic Impact of Integration of EU Financial Markets", November 2002

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 Commission.

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 and business.

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 €350 higher
    • 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 GDP.

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 market integration.

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 markets.

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 integration?

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 access strategies.

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 suppliers.

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 20.

-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 suppliers.


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 too difficult.

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", August 2003.

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 prices.

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 risk.

3.In broad terms Firms have four options in responding to this requirement:

(1) Offer competitive retail prices and seek retail business

(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 (1)

(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 unattractive

(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 outcome.

(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 nor damaging.

(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 trades
  • 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 imagined.

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.

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