financial regulation, banking integration, and business...
TRANSCRIPT
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
Elias Papaioannou, EIB Presentation, February 2014
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
Elias Papaioannou, EIB Presentation, February 2014
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
Elias Papaioannou, EIB Presentation, February 2014
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
Elias Papaioannou, EIB Presentation, February 2014
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.)
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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
Financial Integration and Business Cycle
Synchronization. Theory (cont.)
Key Issues
Productivity (“real”) shocks
Financial shocks (banking system)
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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
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.
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Introduction
Elias Papaioannou, EIB Presentation, February 2014
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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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
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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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
Initial Approach. Schematic Representation
Legislative/regulatory harmonization in financial services (FSAP)
cross-border financial integration business cycle synchronization
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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
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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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
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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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
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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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
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
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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
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
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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
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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Financial Integration and Business Cycle Synchronization
Elias Papaioannou, EIB Presentation, February 2014
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)
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Global Banks and Crisis Transmission
Elias Papaioannou, EIB Presentation, February 2014
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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Global Banks and Crisis Transmission
Elias Papaioannou, EIB Presentation, February 2014
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?
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Global Banks and Crisis Transmission
Elias Papaioannou, EIB Presentation, February 2014
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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Global Banks and Crisis Transmission
Elias Papaioannou, EIB Presentation, February 2014
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
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Global Banks and Crisis Transmission
Elias Papaioannou, EIB Presentation, February 2014
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
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
Elias Papaioannou, EIB Presentation, February 2014
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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Global Banks and Crisis Transmission
Elias Papaioannou, EIB Presentation, February 2014
Way Forward. Europe
Stability of euro area
Banking union
Optimum currency area
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Summary - Conclusion
Elias Papaioannou, EIB Presentation, February 2014
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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Summary - Conclusion
Elias Papaioannou, EIB Presentation, February 2014
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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Summary - Conclusion
Elias Papaioannou, EIB Presentation, February 2014
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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Summary - Conclusion
Thank you
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