From Fragmentation to Financial Integration in Europe
Chapter

Chapter 3. European Union Financial Integration before the Crisis1

Author(s):
Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Author(s)
Luc Laeven and Thierry Tressel 

During the past decades, financial markets in the European Union (EU) integrated at a rapid pace. The integration of financial systems was facilitated by far-reaching political measures by the EU to reduce regulatory obstacles to cross-border activity, promoting a single market in financial services, including by the creation of the euro, which removed exchange rate risks, and through the European Central Bank (ECB) collateral policy, which created a large pool of substitutable assets that could be used for refinancing operations.

The process of integration was strong but uneven. Large banks and insurance companies from advanced Europe established strong local presence in the newly opened markets of emerging Europe. In Western Europe, the creation of the euro and expectations of convergence resulted in a surge in capital inflows from Western to emerging Europe. The process of financial market integration was strong (as also evidenced by the convergence of interest rates) but uneven across countries and markets, and macro-financial (notably sovereign) risks were mispriced. Integration in the euro area went farther in wholesale funding markets and bond markets while retail lending markets remained mostly national. Large EU banks continued their strong expansion abroad and broadened the scope of their activities, becoming larger, more systemic, and more complex to resolve.

This integration took place against the backdrop of financial systems that remained mostly bank-based. With the exception of the United Kingdom, stock and bond markets played a small role in financing the economy. Centers for financial services remained few, including the United Kingdom and smaller economies (Ireland, Luxembourg, and so on). Many countries appeared “over-banked,” either in number of institutions or in volume of bank assets.

Financial integration reduced macroeconomic volatility, but in an uneven manner. Banking integration within the euro area led to reduced fluctuations in output growth since at least 1999, although the effect was uneven across countries and substantially weakened during the most recent period. Moreover, evidence suggested that macroeconomic risks went largely ignored.

Patterns of Financial Integration

Financial integration in the EU increased markedly after the inception of the euro, supported by the single passport and common market. From the inception of the euro to the start of the financial crisis in 2008, the integration of EU banking systems progressed at a fast pace, as reflected in the rapid growth of foreign exposures of EU banks to residents from other EU countries. Between the start of 2000 and the first quarter of 2008, total intra-EU foreign exposures to nonresidents grew by €5.5 trillion (about 215 percent).2 About 40 percent of this deepening of financial integration was accounted for by the combined increased foreign exposures to the euro area periphery from the “core” of the euro area and the United Kingdom (by about €1.6 trillion; Figure 3.1), as well as to emerging EU countries from advanced EU countries (by about €540 billion; Figure 3.2).3

Figure 3.1Net Financial Asset Positions of the Euro Area Periphery in percent of GDP

Source: IMF, International Financial Statistics database.

Figure 3.2Net Financial Asset Positions of Emerging European Union countries in Percent of GDP

Source: IMF, International Financial Statistics and World Economic Outlook databases.

These capital flows from the “core” euro area and the United Kingdom to the periphery of the euro area and to emerging EU countries helped sustain large external imbalances.4 In the euro area, current account balances of Greece, Ireland, Italy, and Spain worsened significantly during the first decade of European Monetary Union, while Portugal’s deficit remained at the very high levels it had reached early in the decade. As a result of the increasing recourse to external financing, net external liabilities of these countries rose sharply, reaching levels close to or above 100 percent of GDP by the end of 2010 in Greece, Ireland, Portugal, and Spain.5 During this period, Germany and a number of other countries in Northern Europe progressively built large current account surpluses, with the current account for the euro area as a whole remaining in broad balance throughout the period. Meanwhile, emerging European countries also experienced sharp deteriorations of their net foreign asset positions.

Financial integration was accompanied by a strong reduction of spreads across EU countries:

  • Sovereign bond markets. The compression of sovereign bond yields in the euro area reached a maximum at the onset of the 2008 financial crisis, when the spreads between German bunds and bond yields of Greece reached 20 basis points only (Figure 3.3).

Figure 3.310-Year Government Bond Spreads vis-à-vis Germany

(percentage points)

Sources: Bloomberg, L.P.; and IMF staff calculations.

  • Interbank markets. There was also a strong convergence of funding costs in wholesale funding markets in the euro area. From the inception of the euro to 2007, the dispersion of rates on unsecured and secured (repo) lending to banks also collapsed. By 2007, the standard deviation of repo rates or unsecured rates (at one-month maturity) had fallen to between 0.5 and 0.7. Furthermore, until the start of the crisis, there was little differentiation of bank credit default swap (CDS) spreads across countries (Figure 3.4).

Figure 3.4Dispersion of 5-Year Credit Default Swap Premiums of Commercial Banks in the Euro Area

Source: European Central Bank.

Note: LTRO = Long-Term Refinancing Operations; OMT = Outright Monetary Transactions.

  • Retail markets. The convergence of funding costs for banks and sovereigns spilled over to retail local markets across member states: (1) deposit rates strongly converged across the euro area; and (2) loan rates also converged significantly across member states.

Yet, integration was uneven across markets and geographies, with remaining fragmentation, notably in several domestic banking markets. Integration went farther in markets such as interbank markets and sovereign bond markets, and was more limited in retail deposit and loan markets, or equity markets:

  • Evidence from euro area banks’ geographical allocation of assets shows that the degree of cross-border integration varied across markets (Appendix 3.1):

    1. Interbank markets. Interbank markets were significantly integrated across borders according to the ECB’s monetary financial institution (MFI) statistics. On the eve of the crisis, almost 40 percent of euro area banks’ interbank claims were vis-à-vis nondomestic banks in the EU.

    2. Bond markets. Bond markets were the most integrated, with cross-border holdings accounting for 54 percent of total holdings of EU bonds by euro area banks at the end of 2007.

    3. Loan markets. Cross-border integration of loan markets remained limited. According to the ECB MFI data, cross-border loans were only a very small fraction of total loans to nonbanks. At the end of 2007, about 85 percent of loans supplied by euro area domestic credit institutions were to domestic residents, 12 percent to residents of other euro area countries, and 3 percent to residents of other EU countries.

    4. Equity markets. Euro area banks had, to some extent, contributed to the integration of equity markets across the EU. At end 2007, about 25 percent of equity holdings of euro area banks were in other EU countries.

  • Intra-EU interbank markets are very large. Evidence suggests that interbank markets are very large in the EU. Before the start of the crisis, claims of euro area banks on other banks in the EU amounted to about 70 percent of EU gross domestic product (GDP), among which about 30 percent of EU GDP were cross-border claims (Figure 3.5). At the end of 2011, the interbank market remained large, in spite of a substantial contraction, and the same ratios were, respectively, 66 percent and 22 percent of EU GDP.

Figure 3.5Interbank Claims of Euro Area (EA) Monetary Financial Institutions on Other Banks in the EU

Sources: European Central Bank, Monetary Financial Institutions database; and IMF, International Financial Statistics and World Economic Outlook databases.

  • EU foreign banks dominate emerging Europe’s retail banking markets but have a more limited presence in euro area countries. Foreign-owned banks account for a very significant share of domestic deposits and loans in emerging EU countries (Figure 3.6), and have remarkably remained stable since the start of the crisis in 2008, partly owing to the Vienna initiative. Deposits held in foreign-owned banks range from 45 percent in Latvia to about 90 percent in Estonia, and are typically much smaller in more mature EU countries, suggesting a much more limited integration of retail markets in these countries. Note, for example, that only about 10 percent of U.K. deposits are held within foreign banks, in spite of a much larger share of foreign banks in total bank assets booked in the United Kingdom. Data on loan shares provides a similar picture, suggesting a much higher local retail presence of foreign banks in emerging European countries than in more mature EU countries (Figure 3.7).

Figure 3.6Share of Deposits in Foreign-Owned Banks

(in percent)

Source: European Central Bank, Consolidated EU Banking Statistics.

Figure 3.7Share of Loans Booked by Foreign-Owned Banks

(in percent)

Source: European Central Bank, Consolidated EU Banking statistics.

  • The dichotomy of foreign bank presence between emerging Europe and euro area countries may be related to “overbanking” in more advanced EU countries. Domestic retail banking is typically large in percent of GDP in more advanced EU countries, and remains instead more limited in emerging Europe. While the penetration by foreign banks in emerging Europe was also a consequence of the banking crises that took place during the transition of the 1990s, differences of profitability and of “saturation” of domestic retail markets may also be a possible explanation for the limited retail presence of foreign banks in most advanced EU countries.

Banking Structures in the European Union

The financial integration took place in the context of a “bank-based” financial system. The EU financial systems are mostly bank-based, as stock and bond markets provide a relatively modest share of the financing to the private sector in most countries (Figure 3.8). Total bank assets account for 283 percent of GDP in the EU, compared to about 65 percent of GDP in the United States. Large banks dominate EU banking systems, but medium-sized banks also play significant roles (Table 3.1). Even so, medium-sized banks, and to some extent small banks, remain an important component of the EU banking system. Indeed, as of end 2011, medium-sized banks and small banks accounted for 63 percent and 9 percent, respectively, of EU GDP.6

Figure 3.8Depth of Financial Sectors

Source: World Bank Financial Structure database (2012).

Note: Data are for 2010, except private credit 2008 for Bulgaria, Czech Republic, Denmark, and Hungary.

Table 3.1Distribution of Banking Assets by Bank Size
Euros (billions)% EU GDP
Large26,780211
Medium8,04063
Small1,0829
Total35,902283
Sources: European Central Bank; and IMF, World Economic Outlook database.
Sources: European Central Bank; and IMF, World Economic Outlook database.

However, the structure of banking systems varies significantly across countries. Countries such as Austria, Germany, and Poland have very large numbers of small credit institutions. The banking systems of countries such as Austria or Germany have traditionally comprised three pillars of (1) private commercial banks, (2) public sector banks, and (3) large numbers of local cooperative banks organized as a network. In Germany, private commercial banks accounted for 36 percent of total bank assets, public sector savings banks—Sparkassen and their associated Landesbanken—for 31 percent of total bank assets, and Volksbanken (cooperative banks) for 11 percent of total bank assets.7 At the other end of the spectrum, countries such as France or Sweden have very small numbers of standalone credit institutions (Figure 3.9).

Figure 3.9Number of Credit Institutions

Sources: European Central Bank, Consolidated Banking Statistics 2011.

Note: For France, data on stand-alone credit institutions are for 2007.

The process of financial integration was to a significant extent the outcome of the cross-border expansion of large EU banks. The main EU banking systems are dominated by a set of global systemically important banks (G-SIBs). These European G-SIBs have grown in size and importance and are highly interconnected with the rest of the global financial system. Their assets more than tripled since 2000, amounting to US$27 trillion in 2010 (Figure 3.10). As key players in global derivatives and cross-border interbank markets (see below section on funding), they are also among the most interconnected G-SIBs. European G-SIBs tend to be larger and more leveraged than their peers.8 In particular, they are very large relative to home country GDP, and in many EU countries, their size may dwarf the capacity of the home government to raise revenues.

Figure 3.10Global Systemically Important Banks: Total Assets

(June 2012)

Sources: Bankscope; Financial Stability Board; and IMF, World Economic Outlook database.

Across EU countries, the distribution of bank assets is broadly aligned with economic size. Larger economies (France, Germany, Italy, Spain, and the United Kingdom) tend to have larger banking systems. However, because of its role as the main financial center of the EU, the United Kingdom accounts for a much larger share of assets of banks residing in the EU than its share of EU GDP. In contrast, Germany, Italy, or Spain each accounts for a smaller share of EU bank assets than its share of EU GDP (Figure 3.11).

Figure 3.11Share of Total Bank Assets Booked in the EU

(end 2011)

Despite an increase in banking integration since inception of the euro, banking integration in the euro area still lags behind that in the United States, where banking integration increased rapidly following interstate deregulation in the 1980s. While cross-border banking activity has grown rapidly in the euro area, the integration of local banking markets remains low on average. Indeed, the non-local share of the banking system in the United States (as measured by the share of the banking system held by banks from other U.S. states) is a multiple of the non-local share of the banking system in the euro area (as measured by the share of the banking system held by banks from much other euro area countries). The non-local shares are computed using information from the Federal Reserve on out-of-state deposits9 held by U.S. bank holding companies, and data from the ECB on financial assets held by financial institutions residing in other euro area countries (Figure 3.12).10

Figure 3.12Non-local Share of Banking System in the United States and Euro Area (1997–2011)

Note: For the United States, share is the fraction of deposits in a state owned by a holding company that has deposits in other states. For the euro countries, share is the fraction of financial instruments invested within a country by financial institutions residing in other euro countries. Data are in percentages.

However, as a result of the integration process, cross-border credit by nonresident banks plays a non-negligible role in several countries with financial centers. Private credit by nonresident banks accounts for a significant portion of bank credit to the real economy in many EU countries, most likely a consequence of the process of financial integration within the EU (more on this below). This contrasts with the experience of a large country such as the United States, where credit by nonresident banks remains relatively small. At the end of 2010, 22 EU countries had loans from nonresidents exceeding 50 percent of GDP (Figure 3.13). Credit by nonresident banks is particularly large in financial centers (Ireland and the United Kingdom), small countries (Cyprus, Malta), in several core euro area countries (e.g., France), and in the Baltics (Estonia, Latvia).

Figure 3.13Loans from Resident and Nonresident Banks

Source: World Bank Financial Structure database (2012). Data are for 2010.

Financial Centers

Financial markets in the EU are concentrated, with financial centers in London and elsewhere playing an important role. U.K.-based banks account for a disproportionate share of EU banking assets (about a quarter of the total) and 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, and Eurobond issuance, among others (Figure 3.14). Indeed, the U.K. financial system plays a central role not only within the EU financial system, but also globally, linking many EU financial systems to the rest of the world. In addition, the asset management industry in the EU is spread over a number of financial centers, with after London also Amsterdam, Dublin, Frankfurt, Luxembourg, and Paris playing significant roles (in addition to offshore centers).11 The emergence and growth of these financial centers rests not exclusively on the importance of comparative advantage and economic clusters but is also due to tax considerations and differences in regulatory requirements.

Figure 3.14aShare of Total Bank Assets Booked in the EU

(end 2011)

Sources: European Central Bank; IMF, World Economic Outlook database.

Figure 3.14bStock Market Capitalization in the U.K. and Rest of the EU, 1990–2010

(in trillions of U.S. dollars)

Source: World Bank, Financial Structure Database.

Even prior to the crisis, there was a discussion on the role of financial centers in the context of a single market, and whether the concentrated nature of financial markets in the EU posed concerns for competition. Mergers and acquisitions have been closely watched under EU rules to ensure that consumer welfare does not suffer from industry consolidation, and some efforts have been made to harmonize taxes and regulatory requirements across jurisdictions, although more progress toward harmonization would benefit the single market for financial services. From a competition perspective, there is also growing concern that financial restructuring in light of current banking problems will result in further industry consolidation.

Smoothing of Economic Cycles

In theory, banking integration could cause higher or lower economic volatility, depending on the prevalence of national versus regional shocks and the degree of product and labor market integration. A large literature has investigated the link between integration of banking markets and the amplitude of business cycles. In a seminal paper, Morgan, Rime, and Strahan (2004) analyze how integration of banks through ownership links and physical presence across U.S. states has affected economic volatility within U.S. states. They find that annual fluctuation in state-level economic growth falls and converges as banks become more integrated (through ownership links) with banks in other states, suggesting that banking integration across U.S. states has made state business cycles smaller and more alike. However, recent work by Kalemli-Ozcan, Papaioannou, and Peydro (forthcoming) finds a strong negative effect of banking integration on the synchronization of economic cycles for a broader set of advanced economies, including in the EU. This difference arises in large part from measuring banking integration using time-varying, country-pair data on bilateral banking flows from the BIS International Locational Banking Statistics. In this section, we combine the insights and approaches in these two papers by analyzing the impact of banking integration on economic fluctuations using time-varying, country-pair data on both bank ownership links and cross-border banking flows.

Regression analysis shows that banking integration within the euro area has led to reduced fluctuations in output growth since at least 1999, although the effect is uneven across countries and substantially weakened during the recent crisis period (see Box 3.1). This suggests that the amplitude of economy cycles across the euro area was reduced after euro adoption, in part due to increased financial integration, thus benefiting the real economy. However, this effect comes primarily from integration through foreign bank presence (inward banking integration), not from cross-border banking flows, even though the latter grew much more rapidly during the run-up to the recent crisis. At the same time, outward banking integration (that is, banking assets held in other states) appears to have increased economic fluctuations at home, suggesting that economies with international banks are vulnerable to shocks from abroad. Additionally, the positive effect of banking integration operates primarily through output, not income growth. Importantly, these benefits from financial integration obtain even though the effect is substantially weakened (or even reversed) during the recent crisis period. Overall, the results are rather weak, suggesting that the benefits of financial integration in term of smoothing of economic cycles have not accrued to all economies.

Box 3.1Economic Fluctuations and Local and Cross-Border Banking Integration in Euro Area Countries

Fluctuations in Real GDP Growth
(1) Local Banking Integration(2) Cross-Border Banking Integration
Variables(A) 1999q1–2012q1(B) 1999q1–2007q4(A) 1999q1–2012q1(B) 1999q1–2007q4
Interstate asset ratio−2.276−12.79***
(3.882)(4.867)
Other states asset ratio1.850**3.406***
(0.886)(0.950)
Total Bank for−0.0398−0.717
International(0.303)(0.753)
Settlements claims/
GDP
Country fixed effects××××
Time fixed effects××××
Observations612419317130
Adjusted R-squared0.3930.4240.3990.400
Robust standard errors in parentheses *** p < 0.01, ** p < 0.05, * p < 0.1, clustered by countryCountries included in regression: Austria, Belgium, Germany, Spain, Finland, France, Greece, Ireland, Italy, Netherlands, and PortugalNotes: Dependent variable is the residual of ln(GDP, t/GDP, t-1) when regressed on country and time FE. IAR denotes Interstate asset ratio, computed as banking assets in country i held by monetary financial institutions (MFIs) from all other Euro countries divided by total banking assets in country i held by domestic and all other Euro countries. OSAR denotes Other states asset ratio (OSAR), computed as banking assets held by MFIs from country i in countries other than country i (including outside euro area) divided by banking assets held by MFIs from country i in country i. IAR and OSAR variables are constructed using quarterly cross-border banking data from the ECB. Cross-border claims are from BIS on a quarterly, bilateral basis. Total BIS claims denote the sum of claims by home country banks on other countries and claims by foreign banks on the home country. Exchange rate for construction of BIS Claims/GDP variable is from the European Central Bank (ECB), using last daily exchange rate of the quarter. Population is at the country level. Regressions include a constant term and control for the labor shares of major industries, as in Morgan, Rime, and Strahan (1994) (coefficients not reported). Sector data is from Eurostat. 19982012, quarterly. GDP denotes real GDP. Nominal GDP data are from the ECB and chain-linked.
Robust standard errors in parentheses *** p < 0.01, ** p < 0.05, * p < 0.1, clustered by countryCountries included in regression: Austria, Belgium, Germany, Spain, Finland, France, Greece, Ireland, Italy, Netherlands, and PortugalNotes: Dependent variable is the residual of ln(GDP, t/GDP, t-1) when regressed on country and time FE. IAR denotes Interstate asset ratio, computed as banking assets in country i held by monetary financial institutions (MFIs) from all other Euro countries divided by total banking assets in country i held by domestic and all other Euro countries. OSAR denotes Other states asset ratio (OSAR), computed as banking assets held by MFIs from country i in countries other than country i (including outside euro area) divided by banking assets held by MFIs from country i in country i. IAR and OSAR variables are constructed using quarterly cross-border banking data from the ECB. Cross-border claims are from BIS on a quarterly, bilateral basis. Total BIS claims denote the sum of claims by home country banks on other countries and claims by foreign banks on the home country. Exchange rate for construction of BIS Claims/GDP variable is from the European Central Bank (ECB), using last daily exchange rate of the quarter. Population is at the country level. Regressions include a constant term and control for the labor shares of major industries, as in Morgan, Rime, and Strahan (1994) (coefficients not reported). Sector data is from Eurostat. 19982012, quarterly. GDP denotes real GDP. Nominal GDP data are from the ECB and chain-linked.

But it has also contributed to a mispricing of risks. Although sovereign bond spreads prior to euro adoption were strongly correlated with indicators of macroeconomic vulnerability such as current account and government debt ratios, during the run-up to the crisis, sovereign risks within the euro area 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 (Figure 3.15). Since the sovereign debt crisis in the euro zone, such macro factors have again become priced (Figure 3.16).

Figure 3.15Sovereign Bond Spreads on German Bonds against Current Account/GDP

Sources: Bloomberg L.P.; IMF, World Economic Outlook database; and authors’ calculations.

Figure 3.16Sovereign Bond Spreads on German Bonds against Gross Government Debt/GDP

Sources: Bloomberg L.P.; IMF, World Economic Outlook database; and authors’ calculations.

These patterns are confirmed in regression analysis of sovereign CDS spreads (relative to Germany) for EU member states (see Box 3.2). These regressions related sovereign CDS spreads to measures of government indebtedness while controlling for other measures of macroeconomic vulnerability, including current account deficits, household debt, and house prices. While government indebtedness (as measured by the ratio of gross government debt to GDP) has been strongly reflected in CDS spreads since the start of the crisis in 2008, this was not the case during the run-up to the crisis.

Box 3.2Sovereign Spreads and Indicators of Macroeconomic Vulnerability (2004–2011)

Dependent variable is average of sovereign CDS

spread relative to German CDS during year
(1)

Full Period:

2004–2011
(2)

Precrisis:

2004–2007
(3)

Crisis Period:

2008–2011
Gross debt of government/GDP8.626*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 index4.634−0.223*6.503
(1.026)(−1.911)(1.059)
Year fixed effects×××
Country fixed effects×××
Observations813645
Adjusted R-squared0.6030.6820.594
Sources: Bloomberg, L.P.; IMF, International Financial Statistics database; and Eurostat.Notes: Countries included in regression: Austria, Belgium, Estonia, Finland, France, Ireland, Italy, Netherlands, Portugal, Slovak Republic, Slovenia, and Spain. All regressions include a constant term (not reported). Robust t-statistics in parentheses. *** p < 0.01, ** p < 0.05, *p < 0.1. CDS = credit default swap.
Sources: Bloomberg, L.P.; IMF, International Financial Statistics database; and Eurostat.Notes: Countries included in regression: Austria, Belgium, Estonia, Finland, France, Ireland, Italy, Netherlands, Portugal, Slovak Republic, Slovenia, and Spain. All regressions include a constant term (not reported). Robust t-statistics in parentheses. *** p < 0.01, ** p < 0.05, *p < 0.1. CDS = credit default swap.

Conclusion

The process of financial integration was very strong before the crisis, both within the euro area and between Western Europe and emerging European countries. The financial integration within the euro area took place mostly in wholesale bank funding markets and sovereign bond markets, while retail markets remained mostly national. In emerging Europe, a large presence of foreign banks built up over time, which relied on internal capital markets within groups to fund their expanding activities in host countries. The integration was underpinned by strong beliefs that capital receiving countries would converge fast toward the per capita income levels of the more developed countries—a belief that was to some extent verified for central European countries, but much less for the periphery of the euro area, where gaps with the relatively more developed countries did not in general diminish.

The integration lacked a macroprudential perspective. The large and sustained capital inflows sowed the seeds of the subsequent reversal of capital flows. Large current account deficits and growing net foreign asset liabilities were allowed to accumulate unchecked, while the risks associated with balance sheet vulnerabilities and asset price bubbles were not priced in. Although some countries, particularly in emerging Europe, took regulatory actions, the mere size of external liabilities made the size of the shock associated with the reversal of capital flows particularly large.

Appendix 3.1. Euro Area Monetary Financial Institutions: Share of Cross-Border Holdings of Financial Assets

Figure A3.1Interbank Assets of Euro Area (EA) Banks

Source: European Central Bank.

Figure A3.2Securities Other than Shares Held by Euro Area (EA) Banks

Source: European Central Bank.

Figure A3.3Loans to Non-Monetary Financial Institutions by Euro Area (EA) Banks

Source: European Central Bank.

Figure A3.4Shares and Equities Held by Euro Area (EA) Banks

Source: European Central Bank.

References

    ChenR.G. M.Milesi-Ferretti and T.Tressel2012External Imbalances in the Euro AreaIMF Working Paper 12/236 (Washington: International Monetary Fund).

    Kalemli-OzcanSebnemEliasPapaioannou and Jose-LuisPeydroforthcomingFinancial Regulation, Globalization and Synchronization of Economic ActivityJournal of Finance.

    Milesi-FerrettiG. M. and LaneP. R.2010Cross-Border Investment in Small International Financial CentersIMF Working Paper 10/38 (Washington: International Monetary Fund).

    MorganDonald P.BertrandRime and Philip E.Strahan2004Bank Integration and State Business CyclesQuarterly Journal of Economics Volume 119 No. 4 pp. 155584.

An earlier version of this chapter appeared partly as a Technical Note prepared by Luc Laeven and Thierry Tressel on “Financial Integration and Fragmentation in the European Union” (European Union: Publication of Financial Sector Assessment Program Documentation), IMF Country Report No. 13, March 2013. The authors thank Charles Enoch, Luc Everaert, Daniel Hardy, Jianping Zhou, and European authorities (especially the European Commission and the European Central Bank) for comments and Lindsay Mollineaux for excellent research assistance.

Valuation effects arising from exchange rate movements are corrected for under the assumption that all claims are in euros.

The euro area periphery includes Greece, Ireland, Italy, Spain, and Portugal. Emerging EU countries include Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia.

Italy’s net financial assets deteriorated moderately as a share of GDP, but were among the five largest in absolute terms at the onset of the crisis.

In the ECB Consolidated Banking Statistics, the size thresholds are defined in relative terms. A bank is large if its assets account for more than 0.5 percent of total EU banking assets, and it is medium sized if its assets account for more than 0.0005 percent of total EU banking assets. On the basis of 2011 data, the two thresholds are, respectively, €180 billion for large banks and €180 million for medium-sized banks.

Germany FSAP Technical Note Banking Sector Structure (July 2011).

In part, this is because European banks tend to follow the universal banking model, which combines a range of retail, corporate, and investment banking activities under one roof. There are some accounting differences that would make the balance sheets of the international financial reporting standards (IFRS)-reporting banks appear more “inflated” than the balance sheets of banks reporting under the U.S. generally accepted accounting principles (GAAP), e.g., netting of derivative and other trading items is only rarely possible under IFRS, but netting is applied whenever counterparty netting agreements are in place under U.S. GAAP.

Using deposits has the advantage that they are a better proxy than assets for residency-based activity of banks, as banks can book assets out of state where loans are made. This is less the case for deposits that remain mostly a local affair.

For the comparison with the United States, as well as for any time that conclusions are drawn on the basis of the ECB cross-border data, a caveat is in order given the way that the data are reported for the EU. Specifically, such data are reported by residency rather than by nationality of the ultimate owner, and therefore miss any dynamics related to the resident subsidiaries of foreign banks. These resident subsidiaries may not have cut back as much on local loans as the direct cross-border loan numbers would suggest, and there are a few examples of core EU banks acquiring these foreign banks since the crisis, even as the Bank for International Settlements (BIS) claims show a decrease in foreign claims in the aggregate.

For a description of small EU off-shore centers, see also Milesi-Ferretti and Lane (2010).

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