Financial Regulation, Banking Integration, and Business Cycle Synchronization

Financial Regulation, Banking Integration, and Business Cycle Synchronization Elias Papaioannou (London Business School, CEPR, and NBER) European Investment Bank Luxembourg February 2014 1

Introduction 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 2

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 3

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. 4

Financial Integration and Business Cycle Synchronization 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 5

Financial Integration and Business Cycle Synchronization Financial Integration and Business Cycle 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.) 6

Financial Integration and Business Cycle Synchronization Financial Integration and Business Cycle Synchronization. Theory (cont.) Key Issues Productivity ( real ) shocks Financial shocks (banking system) 7

Introduction 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

Financial Integration and Business Cycle Synchronization 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 9

Financial Integration and Business Cycle Synchronization 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 10

Financial Integration and Business Cycle Synchronization 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 12

Financial Integration and Business Cycle Synchronization 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 13

Financial Integration and Business Cycle Synchronization 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 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 16

Financial Integration and Business Cycle Synchronization 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). 17

Global Banks and Crisis Transmission Financial Integration and Business Cycle 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) 18

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. 19

Global Banks and Crisis Transmission Our Subsequent Approach Global Banks and Crisis Transmission 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? 20

Global Banks and Crisis Transmission 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 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 22

Global Banks and Crisis Transmission 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 24

Summary - Conclusion Way Forward. Europe Stability of euro area Banking union Optimum currency area 25

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 26

Summary - Conclusion Way Forward. Europe. Optimum Currency Area Criteria Movement of labor-capital Asymmetric shocks Compensating Mechanisms Fiscal transfers (direct) Structural funds Deposit insurance (indirect) EIB? 27

Summary - Conclusion 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 28

Thank you 29