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Blogs review: The renationalization of European finance

What’s at stake: The financial crisis brought the era of rapid financial globalization to a halt. While qualitatively similar than for the rest of the world, this retrenchment has been quantitatively larger and more persistent for Europe, where the dislocation is still affecting the very short-term euro are money markets. Interestingly a similar pattern of regional financial fragmentation also took place in the recovery from the Great Depression in the US.

By: Date: August 25, 2014 Topic: European Macroeconomics & Governance

What’s at stake: The financial crisis brought the era of rapid financial globalization to a halt. While qualitatively similar than for the rest of the world, this retrenchment has been quantitatively larger and more persistent for Europe, where the dislocation is still affecting the very short-term euro are money markets. Interestingly a similar pattern of regional financial fragmentation also took place in the recovery from the Great Depression in the US.

The Great Recession and the reversal in financial globalization

The McKinsey Global Institute writes that for three decades, the globalization of finance appeared to be an unstoppable trend: as the world economy became more tightly integrated, new technology and access to new markets propelled cross-border capital flows to unprecedented heights. But the financial crisis brought that era of rapid growth to a halt. Cross-border capital flows collapsed, and today they remain 60% below their pre-crisis peak.

Source: The McKinsey Global Institute

The reversal in European financial integration

Maurice Obstfeld notes that even before the start of Stage 3 of EMU, financial markets in the prospective members displayed an increasing coherence driven by both the imminent locking of exchange rates and EU market integration measures. The process accelerated after 1 January, 1999. Philip Lane writes that while the qualitative nature of the boom-bust cycle was similar for the broader European region and the global set of advanced economies, the quantitative scale was larger inside the euro area.

The McKinsey Global Institute writes that Europe accounted for 56% of the growth in global capital flows from 1980 through 2007 of the growth in global capital markets, reflecting the increasing integration of European financial markets. But today the continent’s financial integration has gone into reverse. Eurozone banks have reduced cross-border lending and other claims by $3.7 trillion since 2007 Q4, with $2.8 trillion of that reduction coming from intra-European claims. Financing from the ECB and other public institutions now accounts for more than 50 percent of capital flows within Europe. The retrenchment of European banks abroad has been matched by an increase in domestic activity as banks that have received public rescues have faced an expectation to increase home-market lending.

Gian-Maria Milesi-Ferretti and Cédric Tille write that the retrenchment of banks from foreign markets has also proved more persistent in Europe than in the United States, where bank outflows and inflows have moderately resumed in the recovery stage. The sovereign debt market crisis of early 2010 suggests a decline in  substitutability between assets issued by different euro area governments and financial  institutions.

Gene Smiley extension of the seminal Lance Davis paper shows that a similar pattern of regional financial fragmentation took place during the Great Depression in the US monetary union. The convergence of regional interest rates, which began well before 1890, continued into the 1920s decade. But the trends toward convergence of country bank rates and of city bank rates largely stopped and during the recovery from the Great Depression rate divergence occurred. It is not clear why rate convergence ceased during the 1920s. It is also not clear why country bank rates in the western states increased during the initial recovery from the Great Depression. As is well known, bond rates, prime commercial paper rates, and major city bank loan rates fell to extraordinarily low levels during the 1930s recovery. But bank loan rates for the country banks in many western states were relatively high (and even rising) during the recovery.

Source: Gene Smiley

The segmentation of euro area money markets

Mario Draghi writes that the disruptive effects of severe fragmentation in the single financial market have tangible consequences, such as diverging funding costs for banks. This has resulted in the uneven transmission of our interest rate reductions to firms and households across the euro area. For this reason, the ECB has had to identify the most effective policy tools for repairing these disruptions, while remaining within its mandate. Benoit Coeure writes that we have seen pronounced financial de-integration in the interbank market (with the standard deviation of EURIBOR rates across countries within the euro area has moved consistently above the corresponding standard deviation within domestic borders), in cross-border banking activity, and a renationalization of bond holdings during the crisis.

Philip Lane writes that asymmetric information problems have been a central feature of the malfunctioning of the money markets. This has led to a two-tier market structure, with the larger banks possessing the highest credit standing active in the cross-border money markets whereas smaller banks are confined to trading with domestic counter-parties. The segmentation is reflected in pricing data, with interest rates on cross-border inter-bank lending lower than on domestic inter-bank lending.

Benoit Coeure notes, however, that convergence of prices does not necessarily mean integration; it is a necessary but not a sufficient condition. The well-known convergence of sovereign yields across countries in the euro area to very low levels before the financial crisis did not, in itself, imply market integration. In a similar way, when we observe a differentiation of yields across borders, this observation, in itself, is not sufficient evidence of market fragmentation. It may just mean that markets are pricing different risks.  Financial integration is vital in the case of the euro area. A highly integrated financial system is necessary to ensure that the impulses coming from our monetary policy diffuse homogeneously through financial markets across the euro area as a whole.

The increasing reliance on national counterparties in ECB operations

The ECB writes in its Money Market Study that the geographical counterparty breakdown shows an increased reliance on national counterparties, which accounted for 43% of total average daily turnover in 2012 compared with 31% in 2011, at the cost of euro area cross-border activity. The growing significance of perceived country risk in the money market is          also illustrated by the findings of an informal survey conducted among       the major euro area banks represented in the ECB  Money Market Contact Group in March 2012. It showed that country risk is the most significant consideration when assigning counterparty credit lines: 75% of the respondents  said that they apply different haircuts to the assets in repo operations depending on the geographic origin of the counterparty.

Source: ECB

Jorg Asmussen writes that the ECB has taken measures to reduce divergence between countries caused by bank funding risk. We have provided unlimited liquidity to banks in need at fixed interest rates, extending the maturity of our operations up to 3 years. We have allowed national central banks to tailor collateral rules to national conditions. And we have narrowed the interest rate corridor between the deposit rate and our main policy rate to 50 basis points, which reduces cross-country heterogeneity in funding costs.

Some members of the ECB Money Market Contact Group, however, pointed that the participation of only seven NCBs in the recent (2011) collateral expansion raises a question of level playing field for euro area banks from other jurisdictions. Some MMCG members from non-participating jurisdictions remarked that this measure re-defines liquidity of a certain previously illiquid asset class from a regulatory point of view (e.g. in France), which puts banks in non-participating NCBs at a competitive disadvantage. This so called “regulatory liquidity arbitrage” was seen as an undesired implication of the ACCs. ECB Watchers recently pointed out this tension and wondered if the recent decision that the Governing Council has adjusted the eligibility criteria and haircuts applied by NCBs to pools of credit claims and certain types of the ACC eligible under the temporary Eurosystem collateral framework … [to] lead to more consistency of the ACC framework” is aimed at addressing this issue, or is motivated by other reasons.


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