chapter  III
76 Pages

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.