Business Cycle Synchronization Elias Papaioannou (London Business - PowerPoint PPT Presentation

Financial Regulation, Banking Integration, and Business Cycle Synchronization Elias Papaioannou (London Business School, CEPR, and NBER) European Investment Bank Institute Warsaw, Poland September 2013 1

Introduction 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 2 Elias Papaioannou, EIB Institute Presentation

Introduction Relevance  What are the likely consequences of European’s steps towards establishing a “banking union”? • On cross-border banking and financial transactions • On risk sharing and diversification • On the transmission of idiosyncratic (country-specific) shocks • 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 • Optimum currency area 3 Elias Papaioannou, EIB Institute Presentation

Introduction Thanks to my colleagues/co-authors Joint work with  Sebnem Kalemli-Ozcan (Maryland, NBER and CEPR),  Jose Luis Peydro (UPF and CEPR) ,  Fabrizio Perri (Minnesota, NBER and CEPR) 4 Elias Papaioannou, EIB Institute Presentation

Introduction 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. 5 Elias Papaioannou, EIB Institute Presentation

Financial Integration and Business Cycle Synchronization 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 6 Elias Papaioannou, EIB Institute Presentation

Financial Integration and Business Cycle Synchronization 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) 7 Elias Papaioannou, EIB Institute Presentation

Financial Integration and Business Cycle Synchronization Our Initial Approach  Focus on a set of industrial (EU and non-EU countries) over a period of financial stability (1978-2006).  where mostly TFP shocks  Use a (confidential) 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  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 8 Elias Papaioannou, EIB Institute Presentation

Financial Integration and Business Cycle Synchronization Our Initial Approach. Schematic Representation Legislative/regulatory harmonization in financial services (FSAP)   cross-border banking-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 9 Elias Papaioannou, EIB Institute Presentation

Financial Integration and Business Cycle Synchronization Legislative-regulatory harmonization policies in financial services  Construct an index of legislative-regulatory harmonization policies in financial services in EU15 using information on the exact timing of the transposition of the directives of the Financial Services Action Plan (FSAP)  Peculiarity of legal adoption/transposition of EU directives • Quasi-exogenous at the bilateral (country-pair) level 10 Elias Papaioannou, EIB Institute Presentation

Financial Integration and Business Cycle Synchronization 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)  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 11 Elias Papaioannou, EIB Institute Presentation

Financial Integration and Business Cycle Synchronization 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 12 Elias Papaioannou, EIB Institute Presentation

Financial Integration and Business Cycle Synchronization An 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 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). 13 Elias Papaioannou, EIB Institute Presentation

Global Banks and Crisis Transmission 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) 14 Elias Papaioannou, EIB Institute Presentation

Global Banks and Crisis Transmission 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? 15 Elias Papaioannou, EIB Institute Presentation