III.2 Banking across borders
Research on synchronization of real activity and ﬁnancial integration in Europe has intensiﬁed in the past few years. Nevertheless, the implications of integration for ﬁnancial stability remain largely unexplored. This chapter aims at contributing to ﬁlling in this gap. Structural changes in the environment in which ﬁnancial ﬁrms operate, such as increased
real synchronization and advances in ﬁnancial integration, may aﬀect individual and system-wide risk proﬁles of ﬁnancial intermediaries diﬀerentially (see De Nicolò and Kwast 2002; De Nicolò et al. 2004a). On the one hand, enhanced synchronization in real activity may reduce the beneﬁts of cross-country diversiﬁcation. If either the shocks hitting a set of economies (and the relevant borrowers) become more similar or the transmission mechanism of country-speciﬁc shocks becomes stronger, or both, then the pool of diversiﬁable (credit and market) risks available to intermediaries may shrink. On the other hand, ﬁnancial integration may enhance diversiﬁcation opportunities for individual intermediaries, which can rely on enlarged investment opportunities across activities and borders to enhance expected returns for the same amount of risk. Yet, a set of intermediaries may become less diversiﬁed as a whole if their exposures to the same risks increase, either by choice or because the sources of ‘aggregate’ risk have become more similar. Moreover, increased linkages among intermediaries through enhanced common exposures to ﬁnancial markets may make their exposure to contagion more likely. Disentangling these possibly countervailing eﬀects on ﬁnancial stability is the main task of
this chapter. Accomplishing this task requires ﬁrst assessing whether increases in real synchronization and advances in ﬁnancial integration have indeed occurred, since the existing literature does not oﬀer unequivocal answers. Second, it requires constructing measures of systemic risk, and relating them to outcomes of changes in real synchronization and ﬁnancial integration. With regard to real synchronization, several studies have attempted to identify a
‘European business cycle’, but research on the existence of such an object is still ongoing; as a result, few studies have focused on changes in real synchronization.2 Moreover, this literature has dealt almost exclusively with ﬂuctuations of GDP and/or industrial production growth rates. As our focus is on the impact of changes in real synchronization on the risk proﬁles of ﬁnancial institutions through their portfolio choices, synchronization of volatility of growth rates of real activity may be as important as, if not more important than, synchronization in levels. With regard to ﬁnancial integration, recent studies have documented increased con-
vergence in prices of money and bond markets, while noting the slower pace of price convergence in retail bank credit markets (Barros et al. 2005; Baele et al. 2004; Adam et al.
2002). However, the literature exhibits mixed results concerning the integration of equity markets. As stressed by Adjaouté and Danthine (2004), a diﬃculty in assessing integration lies in disentangling pricing eﬀects from changes in fundamentals. Yet we view an assessment of advances in equity market integration as a robust gauge of advances in ﬁnancial integration more generally, since equity markets are ones in which claims on a large variety of countries’ investment opportunities are traded, and integration in such markets does not necessarily follow mechanically from cross-country convergence of interest rates. We proceed in three steps. First, we assess cross-country convergence of the ﬁrst and
second moments of output growth. The consideration of second moments is novel, and turns out to be informative on the changing nature of common versus country-speciﬁc driving forces of the dynamics of real activity. Second, we test whether cross-country convergence of estimates of a discount factor used to price ‘idiosyncratic’ risks in equity markets has occurred, employing a version of the methodology introduced by Flood and Rose (2005). Finally, we document the dynamics of proxy measures of systemic risk based on data for a set of large European banks and insurance companies in the past 15 years. We test convergence in both levels and volatility of these dynamics, and assess whether the risk proﬁles of these ﬁnancial institutions have become more sensitive to common real and ﬁnancial shocks. In doing so, we view the sensitivity of ﬁnancial institutions’ risk proﬁles to common real and ﬁnancial shocks as a useful metric to gauge the implications of increased synchronization in real activity and advances of ﬁnancial integration through the overall exposure of intermediaries to ‘common’ market and credit risks. Our investigation yields three main sets of results. First, we ﬁnd evidence of increased
synchronization in the dynamics of real activity since the early 1980s, in the form of declining trends in the cross-country dispersion in the mean and volatility of industrial production monthly growth rates. These declining trends are found after controlling for common shocks, whose magnitude has become smaller, and are mainly driven by business cycle synchronization. Second, we ﬁnd evidence of increased equity market integration since the early 1990s, in the form of a declining trend in the cross-country dispersion of expected discount factors estimated in each of the European equity markets considered. Third, we ﬁnd lack of evidence of a decline in risk proﬁles for European banks and insurance companies during the period 1990-2004. Importantly, we ﬁnd that these risk proﬁles have converged, and that the sensitivity of bank risk proﬁles to both common real and ﬁnancial shocks has signiﬁcantly increased. An interpretation of these ﬁndings is that increased synchronization in real activity and advances in ﬁnancial integration may have reduced the beneﬁts of cross-country diversiﬁcation. The remainder of the chapter consists of three sections. The ﬁrst assesses synchronization
in real activity, while the second considers integration of equity markets. Then the next constructs indicators of system-wide ﬁnancial risk for a set of systemically important banks and insurance companies in a large set of European countries, and studies their dynamics. A further section assesses the sensitivity of our indicators of systemic risks to real and ﬁnancial shocks. Concluding comments complete the chapter.