## FINANCIAL INTEGRATION AND FRAGMENTATION IN THE EUROPEAN UNION — TECHNICAL NOTE (MARCH 2013) ## Source details **Canonical URL:** [FINANCIAL INTEGRATION AND FRAGMENTATION IN THE EUROPEAN UNION — TECHNICAL NOTE (MARCH 2013)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr1371.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr1371.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr1371.pdf.json) --- ### Executive Summary - Financial markets in the EU integrated rapidly in past decades, aided by political measures to reduce regulatory obstacles, the single passport, the common market, and the creation of the euro. - Integration was strong in wholesale funding and bond markets; retail lending markets remained mostly national. - Cross-border expansion of large banks and insurers from advanced Europe into emerging Europe was significant; EU banks grew larger, more systemic, and more complex to resolve. - From start of 2000 to Q1 2008, total intra-EU foreign exposures to non-residents grew by €5.5 trillion (about 215 percent). - About 40 percent of this deepening was attributable to increased foreign exposures to the EA periphery from the “core” of the EA and the U.K. (by about €1.6 trillion) and to emerging EU countries from advanced EU countries (by about €540 billion). - Integration halted in 2008 after Lehman Brothers; fragmentation first affected emerging Europe and later the EA periphery. - Uncoordinated deleveraging and reduction of cross-border exposures fragmented the financial system, disrupted monetary policy transmission, and amplified sovereign-bank links in the EA periphery. - Policy responses included stabilization measures, steps toward a Banking Union for EA countries, and continued regulatory harmonization via ESAs and ESRB. - Restoring bank solvency is necessary while preserving the single market; national macroprudential flexibility is desirable but European-level systemic risk identification and coordinated macroprudential actions via ESRB and ECB are essential. ### I. EU Financial Integration in Perspective — Key findings and exact figures - Cross-border exposure growth: - €5.5 trillion (about 215 percent): growth in total intra-EU foreign exposures to non-residents between start of 2000 and Q1 2008. - 40 percent: share of the integration deepening accounted for by exposures to EA periphery from core EA and U.K. and to emerging EU countries. - €1.6 trillion: increased foreign exposures to EA periphery from core EA and U.K. - €540 billion: increased foreign exposures to emerging EU countries from advanced EU countries. - External imbalances: - Close to or above 100 percent of GDP: net external liabilities reached by Greece, Ireland, Portugal, and Spain by end-2010. - Market-specific integration and concentration (end-2007 unless noted): - 54 percent: share of cross-border holdings of EU bonds by EA banks. - Interbank claims of EA banks on other banks in the EU pre-crisis: about 70 percent of EU GDP total, about 30 percent of EU GDP cross-border claims. - 85 percent: loans by EA domestic credit institutions to domestic residents. - 12 percent: loans by EA domestic credit institutions to residents of other EA countries. - 3 percent: loans by EA domestic credit institutions to residents of other EU countries. - 25 percent: equity holdings of EA banks in other EU countries. - Banking sector size and structure: - 283 percent of GDP: total bank assets in the EU. - Total EUR 35,902 billion (283 percent of EU GDP) split by size: Large: 26,780; Medium: 8,040; Small: 1,082 (ECB 2011). - US $27 trillion in 2010: assets of European G-SIBs (aggregate reported). - Cost convergence and mispricing pre-crisis: - 20bps: spread between German bunds and Greek yields at onset of 2008 financial crisis (minimum cited). - Standard deviation of repo or unsecured one-month rates: between 0.5 and 0.7 by 2007. ### II. Concentration of financial markets and role of financial centers - U.K.-based banks account for about a quarter of EU banking assets. - London is a major EU and global financial center for equity issuance, syndicated loan markets, foreign exchange trading, and Eurobonds issuance; other key centers include Amsterdam, Dublin, Frankfurt, Luxembourg, and Paris. - The emergence and growth of centers reflect comparative advantage, economic clusters, tax considerations, and regulatory differences. ### III. Adverse effects of financial fragmentation during the crisis - Manifestations and quantified changes (Sept 2008 - Sept 2012): - Intra-EA cross border positions of EA banks have fallen by about €1.5 trillion (Sept 2008 - Sept 2012). - Cross-border exposures to other EU countries have, on aggregate, fallen by €370 billion. - Domestic positions of EA banks (excluding claims on the eurosystem) have increased by about €1.2 trillion. - Quantified fragmentation across market segments (Sept 2008 - Sept 2012): - Interbank markets: - Cross-border claims of EA banks on MFIs located in other EA countries collapsed by €670 billion (42 percent). - Cross-border claims on MFIs in other EU countries collapsed by €285 billion (23 percent). - Domestic claims on other banks fell by €206 billion (3 percent). - Loans to the private sector: - Loans to the domestic non-bank private sector increased by €570 billion (5 percent). - Cross-border loans fell by €450 billion (40 percent) vis-à-vis other EA countries. - Securities other than shares: - Domestic exposures of EA banks increased by €860 billion (43 percent). - Cross-border exposures vis-à-vis other EA countries fell by about €340 billion (55 percent). - Cross-border exposures vis-à-vis other EU countries fell by about €70 billion (50 percent). - Shares and other equities: - Domestic exposures increased by 2 percent. - Cross-border exposures vis-à-vis EA countries fell by 8 percent. - Cross-border exposures vis-à-vis other EU countries fell by 23 percent. - Funding shocks and external effects: - Between June 2011 and December 2011, the 10 largest U.S. MMFs reduced their exposures to French banks by about US$ 100 billion. - BIS estimates: French and German banks reduced their gross US$ assets by respectively US$270 billion and US$ 100 billion between Q2 of 2011 and Q2 of 2012. - Real-economy effects: - Fragmentation amplified sovereign-bank-real economy downward spirals, impaired monetary transmission, and raised concerns of credit crunches for SMEs. ### IV. Empirical evidence on smoothing, mispricing, and determinants of cross-border flows - Banking integration and cycle smoothing: - Main regression conclusion: banking integration within the EA has led to reduced fluctuations in output growth since at least 1999, with effects uneven across countries and substantially weakened during the recent crisis period. - Benefits arise primarily from inward banking integration (foreign bank presence), not from cross-border banking flows; outward banking integration appears to have increased domestic economic fluctuations. - Regression table excerpts and statistics (preserve reported values): - Period labels: (A) 1999q1 - 2012q1 (B) 1999q1 - 2007q4 - IAR -2.276-12.79*** ( 3.882)( 4.867) - OSAR 1.850**3.406*** ( 0.886)( 0.950) - Total BIS claims / GDP -0.0398-0.717 ( 0.303)( 0.753) - Observations 612419317130 - Adjusted R-squared 0.3930.4240.3990.400 - Notes: Dependent variable is the residual of ln(GDP,t/GDP,t-1) when regressed on country and time FE. IAR denotes Interstate asset ratio. OSAR denotes Other states asset ratio. Cross-border claims are from BIS on a quarterly, bilateral basis. Regressions include controls as in Morgan, Rime, and Strahan (1994). 1998-2012, quarterly. - Mispricing of sovereign risk (regression excerpts): - Periods: Full Period: 2004-2011 / Pre Crisis: 2004-2007 / Crisis Period: 2008-2011 - Gross Debt of Government / GDP 8.626*0.071411.80* (1.958)(0.275)(1.983) - Current Account / GDP19.99-2.065***17.66 (1.529)(-4.437)(1.068) - Gross Debt-to-Income Ratio of Households -0.623-0.274***-2.687 (-0.416)(-4.271)(-0.386) - Housing Price Index 4.634-0.223*6.503 (1.026)(-1.911)(1.059) - Observations813645 - Adjusted R-squared0.6030.6820.594 - Notes: Dependent variable is average of sovereign CDS spread relative to German CDS during year. Countries included: Austria, Belgium, Estonia, Finland, France, Ireland, Italy, Netherlands, Portugal, Slovakia, Slovenia, Spain. - Determinants of cross-border leveraging/deleveraging (method and key findings): - Regression specification: yijt = (FCijt - FCijt-1)/GDPj,t-1 with regressors FCijt-1, FCj,t-1, (FCij/FCi)t-1, DXratejt, GDPjt, Xjt and home (i) and host (j) fixed effects. - Sample period: 2005Q1 to 2012Q2; sub-periods: Pre-crisis 2005Q1–2008Q3; Lehman aftermath 2008Q4–2009Q4; EA crisis 2010Q1–2012Q2. - Pre-crisis: bilateral exposures exhibited momentum and concentration; grew faster in countries with largest net IIP liabilities. - Lehman aftermath: reversal of bilateral exposures; declines faster where bilateral exposures were largest. - EA crisis: reversals stronger and portfolio allocation mattered; reversals weaker where host countries accounted for larger share of banks’ foreign activities; bilateral flows correlated with net foreign asset positions. - Cross-sectional emerging Europe vs EA analysis: - Before crisis: little evidence that cumulative increase in foreign liabilities of emerging European countries exceeded EA countries after controls. - After crisis: foreign exposures to Emerging Europe turned more stable than exposures to other countries after controls. - Foreign ownership effect: - Insignificant pre-crisis; strongly and positively significant during crisis period. - Estimated magnitude: a one standard deviation increase in foreign share is associated with foreign liabilities to foreign banks that are higher by 2 percentage points of initial GDP over 2 ½ years. - R-squared vary between 0.26 and 0.5 for cross-sectional specifications. - Sovereign-bank nexus, CDS results and magnitudes: - Bank CDS spreads: a one standard deviation increase in bank CDS spread is associated with a 0.28 percent of GDP average decrease in bilateral exposure of EU banks (column 1 summary). - Sovereign CDS spreads: a one standard deviation increase in sovereign CDS spread is associated with a 0.3 percent of host country GDP decrease in bilateral exposure of EU banks (column 3 summary). - Interaction with foreign ownership: - Impact of a one standard deviation increase in bank CDS spreads translates into a 1.1 percent of GDP decrease in foreign banks’ bilateral exposures if domestic bank presence is at the lowest level (about 9 percent of total bank assets). - The same shock translates into a 0.18 percent of GDP increase in foreign bank exposures if domestic presence is at the sample maximum of about 45 percent of bank assets. - Observations in CDS-related specifications: 2,192; 3,044; 2,868 (depending on column/specification). R2 values around 0.13–0.15. ### V. Demand versus supply in credit shortages — empirical bounds and sectoral results - Evidence from ECB Bank Lending Survey and demand/supply purging methodology: - Method: construct residuals to purge demand from supply and vice versa to obtain lower- and upper-bound estimates of supply effects on loan growth. - Sample period: March 2006 to September 2012 for a sample of EU countries. - Key regression results — Corporates (Table 3): - Supply to corporates: -0.0135 (t = -0.630) in column (1); -0.0277 (t = -1.258) in column (2). - Demand from corporates: 0.110*** (t = 3.798) in column (1); 0.108*** (t = 3.804) in column (2). - Demand from corporates - residual: 0.116*** (t = 3.580) in column (3). - Supply to corporates - residual: 0.0181 (t = 0.710) in column (4). - Constant: 9.849*** (2.606) in (1); 8.863** (2.477) in (2); 9.057** (2.530) in (3); 8.995** (2.513) in (4). - Observations: 222 in each column. - Adjusted R-squared: 0.502 in (1); 0.529 in (2); 0.528 in (3); 0.528 in (4). - Economic magnitude: Based on estimates in column (4), a one standard deviation increase in Demand from corporates implies an increase in loan growth of non-financial companies of 1.7 percentage points (about one-fifth the standard deviation in loan growth). - Key regression results — Households (Table 4): - Supply to households: -0.0384* (t = -1.965) in column (1); -0.0507** (t = -2.595) in column (2). - Demand from households: 0.0811*** (t = 4.439) in column (1); 0.0811*** (t = 4.480) in column (2). - Demand from households - residual: 0.0967*** (t = 3.893) in column (3). - Supply to households - residual: 0.0388 (t = 1.352) in column (4). - Constant: 12.97*** (4.205) in (1); 10.93*** (3.555) in (2); 10.39*** (3.399) in (3); 10.74*** (3.516) in (4). - Observations: 249 in each column. - Adjusted R-squared: 0.116 in (1); 0.171 in (2); 0.172 in (3); 0.172 in (4). - Economic magnitude: Based on results in column (4), a one standard deviation increase in Demand from households implies an increase in household loan growth for house purchase of 2.1 percentage points (about one-fourth the standard deviation in household loan growth). - Interpretation: - Corporates: demand-side factors are economically substantial drivers of loan growth; supply coefficients small or insignificant in baseline specifications (aggregate result may mask SME-specific supply constraints). - Households: supply factors play a more important role than for corporates, but demand remains important in both sectors. ### VI. Policy options and forward-looking recommendations - Core policy imperatives (high-level): - Continue and complete measures to restore bank solvency while preserving the single market for financial services. - Enhance European-level systemic risk identification and macroprudential coordination through the ESRB and ECB to prevent uncoordinated national actions that could further fragment the single market. - Implement the Banking Union for EA countries to provide a common safety net and safeguard financial integration. - Design considerations and cautions: - Creation of a Single Supervisory Mechanism (SSM) should not conflict with existing EU regulatory agencies; harmonization efforts are needed between “ins” and “outs.” - ESM direct recapitalizations could speed addressing solvency issues and relieve contingent liabilities from weak sovereigns. - CRD IV flexibility should be used for macroprudential purposes; ESRB should coordinate macroprudential instrument use. - EU Directive for recovery and resolution of credit institutions, statutory bail-ins, and resolution funds will limit future taxpayer-funded bailouts; SSM should be complemented by a single resolution mechanism with a central resolution authority and common backstops. - Financial sector taxes can address externalities associated with systemic risk but require close coordination among EU member states to avoid single-market distortions. - Overarching stance: - “More and better, not less” financial integration, accompanied by reforms to complete the financial architecture of the monetary union and the broader EU. - Policy action across monetary policy, fiscal policy, bank recapitalization, and institutional reforms is required to restore proper financial intermediation and cross-border credit flows. - Increased financial integration must be supported by a credible financial safety net, higher supervisory quality, and strong resolution tools. *International Monetary Fund — Monetary and Capital Markets Department; Financial Sector Assessment Program: "FINANCIAL INTEGRATION AND FRAGMENTATION IN THE EUROPEAN UNION — TECHNICAL NOTE (MARCH 2013)."* ### 2013. The views expressed in this document are those of the staff team and do not necessarily reflect ### FINANCIAL INTEGRATION AND FRAGMENTATION IN THE EUROPEAN UNION — TECHNICAL NOTE (MARCH 2013) ### Executive Summary - Financial markets in the EU integrated rapidly in past decades, aided by political measures to reduce regulatory obstacles, the single passport, the common market, and the creation of the euro. - Integration was strong in wholesale funding and bond markets; retail lending markets remained mostly national. - Cross-border expansion of large banks and insurers from advanced Europe into emerging Europe was significant; EU banks grew larger, more systemic, and more complex to resolve. - From start of 2000 to Q1 2008, total intra-EU foreign exposures to non-residents grew by €5.5 trillion (about 215 percent). - About 40 percent of this deepening was attributable to increased foreign exposures to the EA periphery from the “core” of the EA and the U.K. (by about €1.6 trillion) and to emerging EU countries from advanced EU countries (by about €540 billion). - Capital flows from core EA and the U.K. to the EA periphery and emerging EU countries helped sustain large external imbalances; net external liabilities in Greece, Ireland, Portugal, and Spain reached levels close to or above 100 percent of GDP by end-2010. - Integration halted in 2008 after Lehman Brothers. Fragmentation first affected emerging Europe as some advanced-EU banks weakened and curtailed liquidity to subsidiaries. - Uncoordinated deleveraging and reduction of cross-border exposures, especially within the EA, fragmented the financial system and disrupted monetary policy transmission; collapses were severe in wholesale funding and sovereign bond markets, amplifying sovereign-bank links in the EA periphery. - Policy responses included stabilization measures, steps toward a Banking Union for EA countries, and continued regulatory harmonization via ESAs and ESRB. - Restoring bank solvency is necessary but must preserve the single market; national macroprudential flexibility is desirable but European-level systemic risk identification and coordinated macroprudential actions via ESRB and ECB are essential. ### I. EU Financial Integration in Perspective #### A. The Pre-Crisis Period — Key Findings - Integration increased markedly since the inception of the euro; from 2000 to Q1 2008 intra-EU foreign exposures rose by €5.5 trillion (about 215 percent). - Geographic composition of flows: - ~40 percent of integration growth represented increased exposures to EA periphery from EA core and U.K.: ~€1.6 trillion. - Increased exposures to emerging EU countries from advanced EU countries: ~€540 billion. - External imbalances: - Current account balances of Greece, Ireland, Italy, and Spain worsened during the first decade of EMU; Portugal’s deficit remained very high. - Net external liabilities reached levels close to or above 100 percent of GDP by end-2010 in Greece, Ireland, Portugal, and Spain. - Convergence of costs: - Sovereign bond spreads compressed markedly; at the onset of the 2008 crisis, spreads between German bunds and Greece reached 20bps only. - Dispersion of one-month repo/unsecured bank lending rates fell to between 0.5 and 0.7 by 2007. - Little differentiation in bank CDS spreads across countries until crisis onset. - Market-specific integration: - Bond markets: At end-2007, cross-border holdings accounted for 54 percent of total holdings of EU bonds by EA banks. - Interbank markets: On eve of crisis, almost 40 percent of EA banks’ interbank claims were vis-à-vis non-domestic banks in the EU; claims of EA banks on other banks in the EU amounted to about 70 percent of EU GDP pre-crisis, with about 30 percent of EU GDP cross-border claims. - Loan markets (retail): At end-2007, about 85 percent of loans supplied by EA domestic credit institutions were to domestic residents, 12 percent to residents of other EA countries, and 3 percent to residents of other EU countries. - Equity markets: At end-2007, about 25 percent of equity holdings of EA banks were in other EU countries. - Retail presence of foreign banks: - Foreign-owned banks hold between 45 percent (Latvia) and about 90 percent (Estonia) of deposits in some emerging EU countries; by contrast, foreign-bank deposit share is much smaller in mature EU countries (about 10 percent in the U.K.). - Foreign-owned bank deposit and loan shares are significantly higher in emerging Europe than in advanced EU countries, partly reflecting the Vienna initiative and historical transition banking crises. #### B. EU Banking Structures — Key Findings - EU financial systems are predominantly bank-based: total bank assets account for 283 percent of GDP in the EU, compared to about 65 percent of GDP in the U.S. - Distribution of banking assets by size (ECB 2011): Total EUR 35,902 billion (283 percent of EU GDP) split as: - Large: 26,780 - Medium: 8,040 - Small: 1,082 - Cross-border banking integration was driven largely by expansion of large EU banks, including European G-SIBs: - European G-SIBs’ assets more than tripled since 2000, amounting to US $27 trillion in 2010. - European G-SIBs are highly interconnected globally, tend to be larger and more leveraged than peers, and can be very large relative to home country GDP—sometimes dwarfing home government revenue-raising capacity. - Comparison with U.S. banking integration: - Banking integration in the EA lags the U.S.; the non-local share of the banking system in the U.S. (measured by out-of-state deposits held by U.S. bank holding companies) is a multiple of the non-local share in the EA (measured by financial assets held by financial institutions residing in other EA countries). #### C. Financial Centers (summary points present in source) - Interbank markets within the EU were very large pre-crisis; despite contraction by end-2011, interbank activity remained significant (66 percent and 22 percent of EU GDP for total and cross-border claims respectively at end-2011). - Foreign bank dominance in emerging Europe’s retail markets contrasted with more limited foreign-bank retail presence in EA countries, possibly reflecting overbanking and market saturation in advanced EU countries. ### II. Adverse Effects of Financial Fragmentation During the Crisis (overview) - Fragmentation following the 2008 crisis led to deleveraging, especially by advanced-EU banks, and withdrawal of liquidity to subsidiaries in emerging Europe. - The Vienna initiative provided coordination and helped stabilize foreign capital in some emerging European countries but did not resolve underlying problems. - Growing sovereign risk concerns and insufficient bank buffers reignited deleveraging; high wholesale funding dependence made banks vulnerable to funding shocks from MMFs and other creditors. - Uncoordinated national actions and simultaneous cross-border exposure reductions disrupted monetary policy transmission and amplified sovereign-bank feedback loops in EA periphery. ### III. Policy Options to Restore Financial Integration (high-level points from source) - Continue and complete measures to restore bank solvency while preserving the single market for financial services. - Enhance European-level systemic risk identification and macroprudential coordination through the ESRB and ECB to prevent uncoordinated national actions that could further fragment the single market. - Implement the Banking Union for EA countries to provide a common safety net and safeguard financial integration. ### Key Statistics and Exact Figures (preserved verbatim) - €5.5 trillion (about 215 percent): growth in total intra-EU foreign exposures to non-residents between start of 2000 and Q1 2008. - 40 percent: share of the integration deepening accounted for by exposures to EA periphery from core EA and U.K. and to emerging EU countries. - €1.6 trillion: increased foreign exposures to EA periphery from core EA and U.K. - €540 billion: increased foreign exposures to emerging EU countries from advanced EU countries. - Close to or above 100 percent of GDP: net external liabilities reached by Greece, Ireland, Portugal, and Spain by end-2010. - 20bps: spread between German bunds and Greek yields at onset of 2008 financial crisis (minimum cited). - Standard deviation of repo or unsecured one-month rates: between 0.5 and 0.7 by 2007. - At end-2007: - 54 percent: share of cross-border holdings of EU bonds by EA banks. - 85 percent: loans by EA domestic credit institutions to domestic residents. - 12 percent: loans by EA domestic credit institutions to residents of other EA countries. - 3 percent: loans by EA domestic credit institutions to residents of other EU countries. - 25 percent: equity holdings of EA banks in other EU countries. - Interbank claims of EA banks on other banks in the EU pre-crisis: about 70 percent of EU GDP total, about 30 percent of EU GDP cross-border claims. - 283 percent of GDP: total bank assets in the EU. - US $27 trillion in 2010: assets of European G-SIBs (aggregate reported). - Vienna initiative: coordinated response cited as stabilizing foreign capital in some emerging European countries (descriptive; no numeric change specified). *International Monetary Fund — Monetary and Capital Markets Department; Financial Sector Assessment Program: "FINANCIAL INTEGRATION AND FRAGMENTATION IN THE EUROPEAN UNION — TECHNICAL NOTE (MARCH 2013)."* ### 8. Financial markets in the EU are concentrated, with financial centers in London ### 8. Financial markets in the EU are concentrated, with financial centers in London and elsewhere playing an important role ### Concentration of EU financial markets and role of U.K. and other centers - U.K. based banks account for a disproportionate share of EU banking assets (about a quarter of the total). - The London-based capital markets and financial institutions account for a substantial share of global finance, including equity issuance, syndicated loan markets, foreign exchange trading, Eurobonds issuance. - The U.K. financial system plays a central role within the EU financial system and globally, linking many EU financial systems to the rest of the world. - The asset management industry in the EU is spread over a number of financial centers; after London also Amsterdam, Dublin, Frankfurt, Luxembourg, and Paris play significant roles (in addition to offshore centers). - The emergence and growth of these financial centers rests not exclusively on comparative advantage and economic clusters but is also due to tax considerations and differences in regulatory requirements. ### Smoothing of economic cycles — empirical findings on banking integration - Theoretical ambiguity: banking integration could cause higher or lower economic volatility depending on national versus regional shocks and product/labor market integration. - Empirical strategy: combines insights from Morgan, Rime, and Strahan (1994) and Kalemli-Ozcan, Papaioannou, and Peydro (2012) by analyzing time-varying, country-pair data on bank ownership links and cross-border banking flows. - Main regression conclusion: banking integration within the EA has led to reduced fluctuations in output growth since at least 1999, with effects uneven across countries and substantially weakened during the recent crisis period. - Source of smoothing: benefits arise primarily from inward banking integration (foreign bank presence), not from cross-border banking flows; outward banking integration appears to have increased domestic economic fluctuations. - Channel: positive effect of banking integration operates primarily through output, not income growth. - Overall: results are rather weak and benefits have not accrued to all economies; effects are substantially weakened (or even reversed) during the recent crisis period. - Regression table excerpts and statistics (preserve reported values): - Period labels: (A) 1999q1 - 2012q1 (B) 1999q1 - 2007q4 - IAR -2.276-12.79*** ( 3.882)( 4.867) - OSAR 1.850**3.406*** ( 0.886)( 0.950) - Total BIS claims / GDP -0.0398-0.717 ( 0.303)( 0.753) - Observations 612419317130 - Adjusted R-squared 0.3930.4240.3990.400 - Notes: Dependent variable is the residual of ln(GDP,t/GDP,t-1) when regressed on country and time FE. IAR denotes Interstate asset ratio. OSAR denotes Other states asset ratio. Cross-border claims are from BIS on a quarterly, bilateral basis. Regressions include controls as in Morgan, Rime, and Strahan (1994). 1998-2012, quarterly. ### Mispricing of sovereign risk during the run-up to the crisis - Pre-crisis: sovereign bond spreads prior to euro adoption were strongly correlated with indicators of macroeconomic vulnerability such as current account and government debt ratios. - Run-up to the crisis: sovereign risks within the EA were seriously mispriced; there was virtually no correlation between sovereign spreads of individual member states (relative to Germany) and their current account or government debt ratios. - Since the sovereign debt crisis in the euro zone, macro factors have again become priced. - Regression excerpts linking sovereign CDS spreads (relative to Germany) to macro indicators (preserve reported values): - Periods: Full Period: 2004-2011 / Pre Crisis: 2004-2007 / Crisis Period: 2008-2011 - Gross Debt of Government / GDP 8.626*0.071411.80* (1.958)(0.275)(1.983) - Current Account / GDP19.99-2.065***17.66 (1.529)(-4.437)(1.068) - Gross Debt-to-Income Ratio of Households -0.623-0.274***-2.687 (-0.416)(-4.271)(-0.386) - Housing Price Index 4.634-0.223*6.503 (1.026)(-1.911)(1.059) - Observations813645 - Adjusted R-squared0.6030.6820.594 - Notes: Dependent variable is average of sovereign CDS spread relative to German CDS during year. Countries included: Austria, Belgium, Estonia, Finland, France, Ireland, Italy, Netherlands, Portugal, Slovakia, Slovenia, Spain. ### Adverse effects of financial fragmentation during the crisis — deleveraging and segmentation - Integration halted during the financial crisis, raising concerns of de-integration of the EA financial system. - Manifestations: - Sharp reversals of capital flows in the periphery of the EA; euro-system and official creditors stepped in to cushion the shock. - Net reliance on ECB funding segmented along national lines; euro-system intermediated funds from surplus countries’ banks to banks in the periphery, resulting in indirect mutualization through “Target 2 imbalances.” - Sharp increase in counterparty risks in EA funding markets amid sovereign risk concerns; sudden changes in availability of wholesale funding in secured and unsecured markets in the second half of 2011 amplified the crisis. - EA banks experienced severe funding pressures starting mid-2011 driven in part by reductions in U.S. money market fund exposures: Between June 2011 and December 2011, the 10 largest U.S. MMFs reduced their exposures to French banks by about US$ 100 billion. - Significant divergence of retail deposit markets since 2010 (Greece) or mid-2011 (Spain); recent stabilization in the periphery possibly related to the OMT announcement. - MFI data evidence: deleveraging by EA banks was a key driver of sharp fragmentation. - Intra-EA cross border positions of EA banks have fallen by about €1.5 trillion (Sept 2008 - Sept 2012). - Cross-border exposures to other EU countries have, on aggregate, fallen by €370 billion. - Domestic positions of EA banks (excluding claims on the eurosystem) have increased by about €1.2 trillion. ### Quantified fragmentation across market segments (Sept 2008 - Sept 2012) - Interbank markets: - Cross-border claims of EA banks on MFIs located in other EA countries collapsed by €670 billion (42 percent). - Cross-border claims on MFIs in other EU countries collapsed by €285 billion (23 percent). - Domestic claims on other banks fell by €206 billion (3 percent). - Loans to the private sector: - Loans to the domestic non-bank private sector increased by €570 billion (5 percent). - Cross-border loans fell by €450 billion (40 percent) vis-à-vis other EA countries (and have been broadly stable vis-à-vis other EU countries). - Note: The reported figures are changes in position and hence include asset write-downs. - Securities other than shares: - Domestic exposures of EA banks increased by €860 billion (43 percent). - Cross-border exposures vis-à-vis other EA countries fell by about €340 billion (55 percent). - Cross-border exposures vis-à-vis other EU countries fell by about €70 billion (50 percent). - Shares and other equities: - Domestic exposures increased by 2 percent. - Cross-border exposures vis-à-vis EA countries fell by 8 percent. - Cross-border exposures vis-à-vis other EU countries fell by 23 percent. ### Drivers of deleveraging and additional international effects - Deleveraging drivers: - Structural forces: adjustment of business models to new regulatory and economic environment, need to strengthen capitalization, reduction of reliance on short-term wholesale funding; implications of new Basel III rules. - Cyclical forces: financial conditions in sovereign and bank funding markets, state of the economy affecting retained earnings, financial fragmentation and repression in the EA. - ECB interventions: LTRO liquidity provision helped cushion funding shocks; OMT stabilized sovereign debt markets with positive knock-down effects on bank access to wholesale markets. - Cross-border and US dollar activities: - EU banks withdrew from overseas markets and US dollar activities; many European cross-border banks had significant overseas activities funded in US dollars with structural funding gaps. - Funding gaps remained significant at the end of Q2 of 2012 despite reductions in US dollar assets of French and German banks. - BIS estimates: French and German banks reduced their gross US$ assets by respectively US$270 billion and US$ 100 billion between Q2 of 2011 and Q2 of 2012. *Italic: IMF staff summary of content unit _cr1371 - 8. Financial markets in the EU are concentrated, with financial centers in London* ### 17. To assess the determinants of the cross-border leveraging and deleveraging in ### 17. To assess the determinants of the cross-border leveraging and deleveraging in the EU ### Methodology and data - Empirical approach: panel regression of quarterly percent changes in bilateral bank exposures between EU home and host countries. - Regression specification (preserved notation): - yijt = (FCijt - FCijt-1)/GDPj,t-1 estimated with regressors: FCijt-1, FCj,t-1, (FCij/FCi)t-1, DXratejt, GDPjt, Xjt and home (i) and host (j) fixed effects. - Sample period: 2005Q1 to 2012Q2. - Sub-periods considered: - Pre-crisis: 2005Q1 to 2008Q3. - Lehman aftermath: 2008Q4 to 2009Q4. - EA crisis: 2010Q1 to 2012Q2. - Data sources: quarterly BIS consolidated banking statistics (ultimate risk basis); IMF World Economic Outlook and BOP-IIP quarterly data; ECB banking system structure data; Bloomberg. - Countries: BIS reporting countries include Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Spain, Portugal, Sweden, and the U.K.; host countries include Austria, Belgium, Bulgaria, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Netherlands, Portugal, Romania, Slovak Rep., Slovenia, Spain, Sweden, and the U.K. ### Explanatory variables and interpretation - Key regressors and intended interpretations: - Initial bilateral exposure (FCijt-1): captures momentum/concentration in bilateral capital flows. Positive coefficient → banks with larger initial exposure increase exposure faster; negative → correction or faster withdrawal. - Total claims of BIS reporting banks on country j (FCj,t-1): measure of gross external liabilities to banks; proxy for external vulnerability to capital outflows. - Share of country j in country i’s banks’ foreign assets (FCij/FCi): indicator of portfolio composition. - Net IIP position in percent of GDP: indicator of external imbalances. - Gross external liabilities of government in percent of GDP; gross external liabilities of resident banks in percent of GDP. - Quarterly macro indicators: annual real GDP growth and inflation rate. - Regressions include home country and host country fixed effects (except where noted for cross-sectional/specifications without host fixed effects). ### Main empirical findings from panel regressions - Pre-crisis (2005Q1–2008Q3): - Bilateral bank exposures to EU countries showed momentum and increasing concentration: banks with greater initial exposures tended to increase exposures faster. - Bilateral exposures grew at a slower pace in countries with the largest gross liabilities to foreign banks (consistent with attention to gross external vulnerabilities). - Bilateral exposures grew faster in countries with the largest net IIP liabilities — i.e., stronger inflows to countries with larger net foreign liabilities, suggesting mispricing of risks (external imbalance indicator ignored or had opposite effect). - No indication of significant portfolio reallocation among foreign exposures of EU banks. - Lehman failure and aftermath (2008Q4–2009Q4): - Reversal of bilateral bank exposures in the EU: bilateral capital flows declined faster where bilateral exposures were the largest — consistent with prudent correction. - No clear evidence that countries with largest net foreign liabilities experienced stronger reversal. - EA crisis (2010Q1–2012Q2): - Reversal of bilateral exposures responded to previous quarter’s bilateral exposure more strongly than during 2008Q4–2009Q4. - Evidence that portfolio allocation mattered: reversal was weaker in host countries where EU banks had a larger share of their foreign activities. - Bilateral bank capital flows were correlated with net foreign asset positions, consistent with a correction mechanism where banks withdrew more from countries with initially larger external imbalances. ### Cross-sectional analysis: emerging Europe (EE) versus EA countries - Approach: cross-sectional regressions of cumulative change in bilateral foreign claims over: - Pre-crisis: 2005Q1–2008Q3 (controls measured at 2005Q1). - Post-crisis: 2008Q4–2012Q2 (controls measured at 2008Q4). - Key control variables included initial bilateral claims as percent of GDP, initial total claims of foreign banks on host as percent of GDP, share of host in foreign portfolio, initial net foreign asset position percent of GDP, initial gross public debt/GDP, initial current account balance/GDP, cumulative percent change in bilateral exchange rate vis-à-vis US dollar. - Findings: - Before the crisis: little evidence that cumulative increase in foreign liabilities of emerging European countries was significantly larger than for EA countries after controls. - After the crisis: foreign exposures to Emerging European countries turned more stable than exposures to other countries (notably peripheral European countries) after accounting for controls. - Foreign ownership (share of foreign banks in total banking assets): - Insignificant pre-crisis; strongly and positively significant during crisis period. - Estimated magnitude: a one standard deviation increase in foreign share is associated with foreign liabilities to foreign banks that are higher by 2 percentage points of initial GDP over 2 ½ years. - R-squared vary between 0.26 and 0.5 for cross-sectional specifications. ### Interpretation: type of financial integration matters - Before the crisis: emerging European countries (large domestic presence of foreign banks and large cross-border intra-group flows) experienced significantly faster build-up of liabilities to foreign banks. - After 2008: emerging European countries experienced a slower reversal of capital flows on average, after controlling for determinants — consistent with a stabilizing role for the Vienna Initiative and for large initial foreign bank presence. - Implication: local presence of foreign banks (potentially funded by intra-group flows) can be stabilizing in a crisis when vulnerabilities are home-grown, though such presence can also contribute to accumulating vulnerabilities pre-crisis. ### Sovereign-bank nexus: CDS analysis and sudden stops - Focus: post-Lehman period, empirically testing links between sovereign and banking fragilities and bilateral foreign exposures. - Specification: panel regression over 2010Q1–2012Q2 (period of observation 2009Q3 to 2012Q2 in some variants), adding sovereign CDS spreads and bank CDS spreads averaged quarterly; some specifications include interaction terms of CDS spreads with foreign ownership. - Key quantitative findings: - Bank CDS spreads: a one standard deviation increase in bank CDS spread is associated with a 0.28 percent of GDP average decrease in bilateral exposure of EU banks (column 1 summary). - Sovereign CDS spreads: a one standard deviation increase in sovereign CDS spread is associated with a 0.3 percent of host country GDP decrease in bilateral exposure of EU banks (column 3 summary). - Interaction with foreign ownership: - Impact of a one standard deviation increase in bank CDS spreads translates into a 1.1 percent of GDP decrease in foreign banks’ bilateral exposures if domestic bank presence is at the lowest level (about 9 percent of total bank assets). - The same shock translates into a 0.18 percent of GDP increase in foreign bank exposures if domestic presence is at the sample maximum of about 45 percent of bank assets. - Regression summary indicators (selected): - Observations reported in table variants: 2,192; 3,044; 2,868 (depending on column/specification). - R2 values around 0.13–0.15 in CDS-related specifications. - Interpretation: - Bilateral changes in foreign bank exposures are significantly and negatively correlated with bank CDS spreads. - Sovereign stress (sovereign CDS) also associated with reductions in bilateral exposures. - Larger foreign bank presence mutes or reverses the negative impact of bank CDS stress on bilateral exposures. ### Real effects of financial integration and disintegration - Fragmentation of EA financial system amplified downward spirals among sovereigns, banks, and the real economy: - Sudden stops in capital flows from cross-border reversals reinforced sovereign-bank balance sheet linkages. - Investors withdrew from sovereign bond markets and interbank markets simultaneously, impairing monetary policy transmission across EA countries. - Stressed banking systems curtailed credit supply; banks raised interest rates on loans; monetary policy became less effective and more pro-cyclical across EA countries. - Specific channels and observations: - Three-year LTROs strengthened sovereign-bank linkages where local banks used funding to purchase domestic sovereign bonds. - Bank funding costs rose in the periphery as cross-border interbank markets fragmented; peripheral banks offered higher deposit rates to attract funds. - Despite ECB policy easing, lending rates in stressed banking systems edged upwards and monetary impulses were not transmitted to the real economy. - Impact on SMEs: - Deleveraging raised concerns about a credit crunch particularly affecting SMEs in peripheral Europe. - Survey evidence (European Commission and ECB Survey on the Access to Finance of SMEs): - Availability of external finance from banks has decreased since 2009 while demand for external finance has increased. - Cross-country variation: availability deteriorated markedly since 2009 in Greece and Ireland; remained fairly stable in Finland and Germany. - Regression analysis suggests deterioration in supply of credit to SMEs is partly driven by financial dis-integration as measured by decline in cross-border BIS claims. *Source: IMF staff summary of empirical analysis in the PDF chapter.* ### 29. However, demand factors play an important role in the lack of borrowing by ### _cr1371 - 29. However, demand factors play an important role in the lack of borrowing by ### Demand versus supply as determinants of low borrowing - Limited access to finance is not reported by most firms to be their main challenge; limited demand for products is the most common obstacle in the SME survey, indicating that demand for finance has reduced as well. - Regression analysis shows the demand for credit is closely associated with declines in GDP, while the availability of credit is not. - ECB bank lending survey data: lending standards for corporates and households have stabilized, while credit demand — especially for corporates — continues to fall (both measured using the diffusion index). Lending standards and credit demand are driven by common factors (e.g., economic conditions), complicating causal interpretation in the absence of exogenous supply shifts. ### Empirical approach: purging demand and supply to bound effects - Objective: disentangle whether changes in lending standards (supply) or credit demand conditions drive loan growth by purging demand from supply factors and vice versa. - Data and sample: ECB bank lending survey responses; regressions estimated separately for lending to corporates and households; sample period March 2006 to September 2012 for a sample of EU countries. - Method: - Basic regression: dependent variable = growth rate of loans to non-financial corporations in a given quarter; ΔS = change in lending standards (higher = relaxation = increase in supply); ΔD = change in demand for loans. - Lower-bound estimate of supply effect: use residual S̄ (residual of country-specific OLS regression of S on D) in place of ΔS. - Upper-bound estimate of supply effect: use residual D̂ (residual of country-specific OLS regression of D on S) in place of ΔD. - Regressions estimated using OLS with quarterly fixed effects. Purging yields upper and lower bounds on the effect of supply-side factors on credit growth. ### Key regression results — Corporates (Table 3) - Dependent variable: Growth rate of loans to non-financial companies. - Coefficients and notes (all values preserved exactly as in source): - Supply to corporates: -0.0135 (t = -0.630) in column (1); -0.0277 (t = -1.258) in column (2). - Demand from corporates: 0.110*** (t = 3.798) in column (1); 0.108*** (t = 3.804) in column (2). - Demand from corporates - residual: 0.116*** (t = 3.580) in column (3). - Supply to corporates - residual: 0.0181 (t = 0.710) in column (4). - Constant: 9.849*** (2.606) in (1); 8.863** (2.477) in (2); 9.057** (2.530) in (3); 8.995** (2.513) in (4). - Quarter Fixed Effects: xxxx - Observations: 222 in each column. - Adjusted R-squared: 0.502 in (1); 0.529 in (2); 0.528 in (3); 0.528 in (4). - Source: ECB Bank Lending Survey. Notes: Robust t-statistics in parentheses *** p<0.01, ** p<0.05, * p<0.1. - Countries in sample are Austria, Cyprus, Estonia, Germany, Italy, Luxembourg, Luxembourg, Malta, Netherlands, Portugal, Slovenia, Spain. - Economic magnitude (reported): - Based on estimates reported in column (4) of Table 3, a one standard deviation increase in Demand from corporates implies an increase in loan growth of non-financial companies of 1.7 percentage points. This amounts to about one-fifth the standard deviation in loan growth of non-financial companies. ### Key regression results — Households (Table 4) - Dependent variable: Growth rate of household loans for home purchase. - Coefficients and notes (all values preserved exactly as in source): - Supply to households: -0.0384* (t = -1.965) in column (1); -0.0507** (t = -2.595) in column (2). - Demand from households: 0.0811*** (t = 4.439) in column (1); 0.0811*** (t = 4.480) in column (2). - Demand from households - residual: 0.0967*** (t = 3.893) in column (3). - Supply to households - residual: 0.0388 (t = 1.352) in column (4). - Constant: 12.97*** (4.205) in (1); 10.93*** (3.555) in (2); 10.39*** (3.399) in (3); 10.74*** (3.516) in (4). - Quarter Fixed Effects: xxxx - Observations: 249 in each column. - Adjusted R-squared: 0.116 in (1); 0.171 in (2); 0.172 in (3); 0.172 in (4). - Source: ECB Bank Lending Survey. Notes: Robust t-statistics in parentheses *** p<0.01, ** p<0.05, * p<0.1. - Countries in sample are Austria, Cyprus, Estonia, Germany, Italy, Luxembourg, Luxembourg, Malta, Netherlands, Portugal, Slovenia, Spain. - Economic magnitude (reported): - Based on results in column (4), a one standard deviation increase in Demand from households implies an increase in household loan growth for house purchase of 2.1 percentage points. This amounts to about one-fourth the standard deviation in loan growth of household loans for home purchase. ### Interpretation and sectoral differences - For corporates: - Demand-side factors are economically substantial drivers of loan growth; supply coefficients are small or statistically insignificant in baseline specifications. - The corporate-sector results are aggregated and may not directly infer the relevance of supply factors for lending to SMEs. - For households: - Supply factors play a more important role in lending to households than in lending to corporates. - Demand factors play a similar role in lending to households and to firms. ### Broader conclusions on financial integration and policy implications - Evidence suggests real effects of financial disintegration and deleveraging are mitigated by policy responses and sharp declines in aggregate demand, although pockets of vulnerabilities and signs of credit supply shocks remain. - Increased financial integration would be beneficial to credit conditions in individual member states. - Policy coordination is necessary to level the playing field and counter market forces contributing to deleveraging and fragmentation; uncoordinated actions have reduced cross-border exposures and disrupted monetary transmission. - Establishment of a banking union (BU) with common supervision, resolution authority and financial safety net would: - Substantially reduce tail risk that an individual member state cannot honor its financial safety net. - Help delink banks and sovereign risk. - Improve supervision quality and resolution coordination for cross-border banks. - Be more urgent for EA countries, though other EU countries would benefit from joining the BU. - Design considerations and cautions: - Creation of a Single Supervisory Mechanism (SSM) should not conflict with existing EU regulatory agencies (e.g., EBA); harmonization efforts are needed between “ins” and “outs.” - ESM direct recapitalizations could speed addressing solvency issues and relieve contingent liabilities from weak sovereigns. - Limits on size and activities of financial institutions are debated; issues can be addressed via improved supervision, resolvability, cross-border bail-in arrangements, and a BU. - Financial sector taxes can address externalities associated with systemic risk but require close coordination among EU member states to avoid single-market distortions. - CRD IV flexibility should be used for macroprudential purposes, not to protect national approaches that impede integration; the ESRB should coordinate macroprudential instrument use. - EU Directive for recovery and resolution of credit institutions, statutory bail-ins, and resolution funds will limit future taxpayer-funded bailouts; SSM should be complemented by a single resolution mechanism with a central resolution authority and common backstops. ### Forward-looking summary - The appropriate stance is “more and better, not less” financial integration, accompanied by reforms to complete the financial architecture of the monetary union and the broader EU. - Policy action to date mitigated deleveraging, but more is needed across monetary policy, fiscal policy, bank recapitalization, and institutional reforms to restore proper financial intermediation and cross-border credit flows. - Increased financial integration must be supported by a credible financial safety net, higher supervisory quality, and strong resolution tools—progress toward banking union, centralization and strengthening of supervisory and resolution frameworks, harmonization of depositor guarantee schemes, and strengthened capital requirements under CRD IV are required. *Source: _cr1371 - 29. However, demand factors play an important role in the lack of borrowing by* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr1371.pdf_