Economic Integration and Financial Stability: A European Perspective

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Economic Integration and Financial Stability A
European Perspective

• Gianni De Nicolò and Alexander Tieman
• International Monetary Fund
• The views expressed in this paper are those of
  the authors and do not necessarily represent
  those of the IMF.

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Motivation

• The implications of economic integration for
  financial stability are largely unexplored
• This paper contributes to fill in this gap
• We focus on
• synchronization of real activity
• financial integration
• financial risk at large financial institutions

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Integration and financial risk

• Increased synchronization of real activity may
  reduce cross-country diversification benefits for
  intermediaries.
• Increased financial integration may enhance
  diversification benefits for individual
  intermediaries..... yet a set of intermediaries
  may become more exposed to (common) aggregate
  (credit and market) risk
• synchronization in real activity and financial
  integration viewed as risk factors affecting the
  overall exposure of intermediaries to credit and
  market risks.

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Assessing these links requires...

• To determine whether synchronization of real
  activity and financial integration have indeed
  progressed in a significant way.
• To construct measures of systemic risk at
  financial institutions and assess changes in
  their sensitivity to proxy measures of common
  real and financial shocks.
• We do this in three steps

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Step 1 Synchronization of real activity

• Assess convergence in levels and volatility of
  output growth
• Measure
• cross-country convergence of the first and
  second moments of industrial production growth.

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Step 2 Equity Market Integration

• Assess progress in equity market integration
• Measure
• cross-country convergence in a discount
  factor used to price idiosyncratic risk
• (expected marginal rate of substitution, EMRS,
  a version of Flood and Roses (JME, 2005)
  methodology)

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Step 3 Financial Risk

• Document systemic financial risk at large
  financial institutions since 1991.
• Assess whether systemic financial risk measures
  have increased their sensitivity to common real
  and financial shocks.
• Measure of financial risk
• Portfolio Distance-to-Default (DD)

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Findings on integration

• Increased synchronization of real activity since
  the early 1980s.
• Increased equity markets integration since the
  early 1990s.

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Findings on financial risk and integration

• Lack of evidence of a decline in risk profiles
  for European financial institutions (as in the
  U.S.) the dark side of diversification.
• Risk profiles have converged
• The sensitivity of bank risk profiles to common
  real and financial shocks has increased since the
  mid-1990s

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Implications

• The integration process may not necessarily
  result in heightened financial stability.
• Enhanced monitoring of system-wide risk profiles
  of financial institutions appears of increasing
  importance as integration progresses.

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Overview

• Synchronization of real activity
• Equity Market Integration
• Financial risk
• Links integration/financial risk

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Synchronization of Real Activity

• Model of the cross-country variance (dispersion)
  of growth and volatility of IP growth
• Does the cross-country variance (dispersion) of
  IP growth and volatility exhibit a significant
  downward trend?
• Control for possible reduction in dispersion due
  to declines in size of common shocks
• RESULT Cross-country variance of IP growth and
  volatility has decreased since the 1980s

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Equity Market Integration

• Estimate the expected marginal rate of
  substitution (EMRS) for each country from equity
  markets data.
• Model of cross-country variance (dispersion) of
  EMRS levels and volatility
• RESULT Cross-country variance of EMRS has
  decreased over time since early 1990s

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Systemic Financial Risk

• We calculate the Distance-to-Default (DD) for a
  portfolio of publicly traded large European banks
  and insurance companies.
• Lower (higher) values of the portfolio DD imply
  a higher (lower) probability of the firms joint
  failure lower bound.
• DD does not appear to exhibit an upward trend
  (1991-2004) gt financial risk has not decreased

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Explanations

• Volatility of non-interest income larger than
  interest income
• High correlation between interest and
  non-interest income (0.79 for EU-15)
• Increased exposure to common financial shocks

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The Dark Side of Diversification

• Large European banks may have used their larger
  capital buffers to make higher risk/higher return
  investments.
• This Dark Side of Diversification is also found
  for U.S. banks
• Risk profiles have converged.

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Links Integration/Financial Risk

• Monthly changes in DD regressed on proxy measures
  of
• (i) a proxy measure of the common component of
  growth in real activity
• (ii) a proxy measure of common financial shocks
  (market index)

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Results

• Overall, increased sensitivity of bank systemic
  risk measures to real shocks and financial shocks
  (Table 6)
• Results for insurance are similar qualitatively,
  but weaker (Table 7)

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Conclusion

• Increased synchronization of real activity and
  financial integration may have a significant
  impact on (systemic) financial risk
• More prominence to monitoring higher risk/higher
  return investments at large, systemically
  important, financial intermediaries.