financial regulation, banking integration, and business...

Financial Regulation, Banking Integration, and

Business Cycle Synchronization

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Elias Papaioannou (London Business School, CEPR, and NBER)

European Investment Bank

Luxembourg

February 2014

Elias Papaioannou, EIB Presentation, February 2014

Questions

1. What is the impact of financial globalization (e.g., banking integration) on

business cycle synchronization?

• Has cross-border banking enabled the transmission of the recent crisis (2007-

2009) from a corner of the US capital markets to the rest of the world?

• Does financial integration leads to decoupling or increased synchronicity (via

contagion) of business cycles (in tranquil times)?

2. What has been the effect of the euro on cross-border capital flows, financial

–and banking in particular- integration?

• How has the euro affected financial integration across Europe?

• Currency risk; trade; legislative-regulatory harmonization policies in financial

services

• Implications for “banking union” project

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Introduction


Relevance

What are the likely consequences of European’s steps towards establishing a

“banking union”?

• On cross-border banking and international financial transactions

• On risk sharing and diversification

• On the transmission of idiosyncratic (country-specific) shocks across Europe

• On the spread of shocks to the financial system

Functioning of monetary union (e.g., monetary policy, fiscal policy, political

economy)

• Easier; harder

• Supportive policies (fiscal transfers, EIB’s role)

• Optimum currency area

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Introduction


Research

Financial Regulation, Financial Globalization, and the Synchronization of Economic

Activity (with S. Kalemli-Ozcan and J.-L. Peydro), Journal of Finance, June 2013, 68(3):

1179-1220.

Global Banks and Crisis Transmission (with S. Kalemli-Ozcan and F. Perri). Journal of

International Economics, May 2013. 89(2): 495-510.

What Lies Beneath the Euro’s Effect on Financial Integration? Currency Risk, Legal

Harmonization, or Trade? (with S. Kalemli-Ozcan and J.-L. Peydro-Alcalde). Journal of

International Economics, May 2010, 81(1): 75-88.

What Drives International Financial Flows? Politics, Institutions and Other Determinants.

Journal of Development Economics, March 2009, 88(2): 269-281.

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Introduction


Financial Integration and Business Cycle

Synchronization. Some Theory.

International real business cycle model: financial (banking) linkages magnify

idiosyncratic (country-specific) shocks in the real economy (productivity)

capital reallocation across countries divergence of output growth

International finance models: diversification benefits are relatively stronger

when business cycles are asynchronous

International specialization models: financial integration enables specialization

(comparative advantage) leading to less synchronized cycles (as long as trade is

mostly across sectors)

Contagion: global banks respond to “balance sheet” shocks to the financial

system by pulling funds from all countries

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Financial Integration and Business Cycle Synchronization



Synchronization. Empirics

Challenges to identification

Isolating countries-periods where financial/banking or total-factor-productivity

shocks are the key drivers of output fluctuations

Heterogeneity between developed, emerging, and under-developed countries (nature of shocks, institutions, politics, etc.)

Accounting for global shocks (e.g., exposure to ABS-MBS, shadow banking system)

Accounting for country (or even country-pair) factors that may jointly affect

growth patterns and financial linkages (e.g., trust, “distance” broadly defined)

Reverse causation (e.g., diversification motive vs. amplification mechanism)

Measurement issues (e.g., flows via off-shore centers, role of subsidiaries, etc.)

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Synchronization. Theory (cont.)

Key Issues

Productivity (“real”) shocks

Financial shocks (banking system)

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Research (1). Initial Approach

Financial Regulation, Financial Globalization, and the Synchronization of Economic

Activity (with S. Kalemli-Ozcan and J.-L. Peydro), Journal of Finance, June 2013, 68(3):

1179-1220.

What Lies Beneath the Euro’s Effect on Financial Integration? Currency Risk, Legal

Harmonization, or Trade? (with S. Kalemli-Ozcan and J.-L. Peydro-Alcalde). Journal of

International Economics, May 2010, 81(1): 75-88.

8

Introduction


Initial Approach. Data-Sample

Focus on a set of industrial (EU and non-EU countries) over a period of financial

stability (1978-2006).

mostly “real” (productivity, TFP) shocks

Use a (proprietary) dataset on cross-border banking (little classical error-in-variables)

Current policy focus; activities of global banks

By far the largest component of international financial transactions (50% in past

decade; more than 2/3 in the 1980s and 1990s)

Exploit for identification

• Changes over time in cross-border financial linkages within pairs of countries

• Account for global (common to all countries) shocks

• Focus on the component of (changes of) financial linkages that is explained

by legislative-regulatory policies in financial services

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Initial Approach. Identification

Focus on changes over time in cross-border financial linkages within pairs of

countries

• Account for global (common to all countries) shocks

• Account on hard-to-measure bilateral (country-pair) factors (e.g., trust,

cultural ties, distance, etc.)

Focus on the component of (changes of) financial linkages that is explained by

legislative-regulatory policies in financial services

• Isolate one-way effect of financial integration on output synchronization

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Initial Approach. Schematic Representation

Legislative/regulatory harmonization in financial services (FSAP)

cross-border financial integration business cycle synchronization

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Initial Approach. Schematic Representation

Legislative/regulatory harmonization in financial services (FSAP)

cross-border financial integration business cycle synchronization

Needed

Construct an index of legislative-regulatory harmonization policies in financial

services in EU15 using information on the exact timing of the transposition of

the FSAP directives

Peculiarity of legal adoption/transposition of EU directives

• Quasi-exogenous at the bilateral (country-pair) level

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The Financial Services Action Plan (FSAP)

EU Commission launched in the end of 1998 the Financial Services Action Plan

FSAP were mainly contained in a set of EU-wide laws (27 EU Directives and 2

EU Regulations).

• Banking; Insurance; Securities (Corporate law/governance)

EU Directives do not mechanically become enforced across national borders (in

contrast to Regulations).

EU countries delay the transposition of the Directives into national law.

Use information from the Commission on the implementation of each of the 27

Directives of the FSAP.

Examples: Money laundering Directive. Directive on insider dealing and market

manipulation. Directive on payment systems. Prospectus Directive

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Results

1. Across country-pairs financial integration is strongly positively correlated

with business cycle synchronization

• Distance (cultural, economic ties, similarities, common shocks, etc.)

• In line with previous works and “conventional wisdom”

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Results





2. When we focus on changes within each pair of countries then a strong negative

association emerges

• As countries become more integrated and conditional on global factors, business

cycle patterns on average diverge

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Results





2. When we focus on changes within each pair of countries then a strong negative

association emerges

• As countries become more integrated and conditional on global factors, business

cycle patterns on average diverge

3. The (exogenous) component of changes in financial integration within pairs

of countries that is driven by legislative-regulatory harmonization policies

in financial services is associated with divergence of business cycles

• One-way (causal) effect of integration on synchronization

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Additional (Policy Relevant) Result.

Legal Convergence and Financial Integration

Conventional wisdom: the elimination of currency risk associated with the

introduction of the euro has been the key driving force for European financial

(banking) integration

EMU – complex project: Besides monetary unification entailed a set of reforms

to homogenize the legal and regulatory infrastructure (Financial Services Action

Plan)

Our evidence: approximately a third of the effect of the euro on cross-border

financial transactions stems from legal convergence (rather than the elimination

of currency risk).

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Synchronization in Turbulent Times

What about the crisis?

Have financial linkages –mostly by banks- contributed to the spread of the

crisis? (contagion)

Quick Answers

Conventional wisdom: Yes.

Empirical evidence: Maybe (mixed)

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Global Banks and Crisis Transmission


Research

Global Banks and Crisis Transmission (with S. Kalemli-Ozcan and F. Perri). Journal of

International Economics, May 2013. 89(2): 495-510.

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Our Subsequent Approach


Reassess these key policy and research inquires

Examine whether there is a structural break on the association between financial

(banking) integration and output synchronization during the crisis period (2007-

2009/10)?

Are countries linked more to the US financial system experienced more

synchronized downturns during 2007-2009?

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Global Banks and Crisis Transmission. Empirical Results

1. During the recent period the association between financial integration and

output synchronization has turned positive!

• Indicates that origin of shocks was financial (on the banking system) –rather than

on the “real” economy

• Direct evidence of financial contagion at a macro-scale

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2. Linkages to the US financial system at the onset of the crisis are associated

with more synchronized business cycles (contractions)

• This result emerges only when we consider indirect exposure to the US via the

Cayman Islands; indicates the importance of small off-shore centers

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2. Linkages to the US financial system at the onset of the crisis are associated

with more synchronized business cycles (contractions)

• This result emerges only when we consider indirect exposure to the US via the

Cayman Islands; indicates the importance of small off-shore centers

3. Similar (though not that large) patterns emerge when we focus on some

other periods of financial/banking troubles (e.g., Scandinavian countries in early

1990s; Japan in mid-1990s)

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Global Banks and Crisis Transmission.

Theoretical Reconciliation of Empirical Results

Build a dynamic stochastic general equilibrium model allowing for both

• Shocks in productivity (real economy); [IRBC models]

• Shocks on banks’ balance sheet (finance); [financial contagion models]

Examine quantitatively model’s fit in explaining both

• Negative association between financial integration and output

synchronization during tranquil times

• Positive association between financial integration and output

synchronization during financial crisis times

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Way Forward. Europe

Stability of euro area

Banking union

Optimum currency area

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Summary - Conclusion


Way Forward. Stability of Euro Area

In tranquil times an increased degree of financial (banking) integration

amplifies total-factor-productivity shocks (strong theoretical support)

• More asynchronous business cycles (mostly in investment and employment)

• Non-synchronized bond and stock returns

Relevance

• Conduct of monetary policy

• Risk sharing and diversification (weak evidence)

• Compensating mechanisms

• fiscal transfers?

• Lending by EU institutions (EIB)

• Crisis management

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Way Forward. Europe. Optimum Currency Area

Criteria

• Movement of labor-capital

• Asymmetric shocks

Compensating Mechanisms

• Fiscal transfers (direct)

• Structural funds

• Deposit insurance (indirect)

• EIB?

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Way Forward. Banking Union

Banking union will most likely further integrate European capital markets

and banking activities

• Risk sharing and diversification

• Growth effects; investment; stability

But an increased degree of banking integration will most likely

• Amplify country-specific shocks in tranquil times

• Destabilize the monetary union during financial crisis periods (increased

synchronization lower benefits of diversification when needed)

Compensating Mechanisms

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Thank you

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