26 September 2012

VoxEU: Banking integration - Friend or foe?

Is a banking union the answer to Europe's woes? This column by Sebnem Kalemli-Ozcan and Elias Papaioannou argues that banking union is no panacea – and it may actually make monetary policy harder. It urges Europe's policymakers to re-evaluate their proposals.

Will a banking union ‘complete’ monetary unification, helping to narrow within eurozone imbalances and synchronise the asymmetric cycles of Member States? Academic research has not been helpful in answering this question since, according to the theory, financial integration may lead to a higher level of business cycle synchronisation but it can also cause a ‘decoupling’ of business cycles between these interconnected economies. The key issue is the nature of shocks that hit the economies.

Take the case of two integrated economies, where one of the two is hit by a negative shock. If the shock hits the banking sector, then problems in one country are likely to spread to others, as global banks (operating in both countries) will probably pull funds from the non-affected country to cover their losses or maintain the regulatory capital requirements. This in turn will lead to contagion, making the business cycles of the interlinked countries more synchronised. Recent research indeed shows that many global banks pulled out from many European countries and emerging markets after the fall of 2008, when the financial crunch in the US capital markets intensified.

If, however, the negative shock hits the productivity of firms, businesses, and entrepreneurs in a country, while banks stay (relatively) healthy, then the return to capital falls and banks pull funds out from the effected country, amplifying the initial shock; this in turn makes the business cycles (and especially the investment component of the national account) of financially interconnected economies to diverge. Take the case of Greece nowadays. Given the negative shock to the productivity of the economy it should not be that surprising that European financiers pull out their capital. The huge reallocation of capital from the countries of the European south to the core of the eurozone can be explained through this mechanism that operates via integrated banks during tranquil times. Before the crisis, during 2001-2007, the same mechanism seems to have been in place: but during this period capital was allocated from the European core to the periphery as Greece, Spain, Portugal, and Ireland experienced a productivity boom.

What is the way forward? The standard textbook theories of financial integration also have implications about consumption co-movement and risk sharing. Financial integration makes output cycles of integrated economies to diverge but under standard assumptions consumption cycles may converge as financial integration facilitates international diversification and risk sharing. While research shows that there are some positive effects of financial integration on risk sharing and consumption smoothing, the economic magnitude is small or moderate at best for countries, though sizeable within federations. While the authors have not studied this effect yet for European economies from causal inference, it seems like consumption cycles are not converging at the moment: southern European countries are getting more improvised with lower levels of consumption and higher levels of unemployment relative to the northern countries. Hence it might be indeed true that financial integration is not complete and can be complete with a banking union that allows debt mutualisation and a central supervision of all banks.

Of course, the key difference between Europe and the US is that the US banking union not only works via central supervision and common deposit insurance but also via existence of institutions such as FDIC that orchestrate the resolution process by taking up failed banks. Most importantly, in the US the federal government buffers asymmetric (state-level) shocks via fiscal transfers. It is thus still unclear how a currency union with an almost perfect degree of banking integration but without fiscal backstops and transfers can operate. Economic research, both theoretical and empirical, suggests that by itself banking union (or complete financial integration) will not dampen business cycles of Member States. Actually a higher degree of financial integration may lead to more divergent output cycles, in spite of potentially converging consumption cycles in the future. Moreover financial integration and banking union in particular may be a destabilising force when shocks hit the financial sector in a crisis.

The authors' arguments should not be taken as being against the recent proposals for enhanced regulation-supervision of financial institutions towards the creation of a ‘banking union’ within Europe. They are simply pointing out the fact that academic research suggests that by itself banking union is not a panacea to Europe’s economic woes and may make the conduct of monetary policy harder. This implies that European policymakers must re-evaluate proposals towards the creation of some form of fiscal union.

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