Financial market integration in the US: lessons for Europe?
1. Motivation *
The introduction of the euro The introduction of the euro took place principally between 31 December 1998, when the exchange rates between the euro and legacy currencies in the Eurozone became fixed, and early 2002, when euro notes and coins were introduced and the legacy currencies withdrawn. in 1999 has marked a milestone in the integration of financial markets in Europe. (1) The question to what extent the degree of interregional in·ter·re·gion·al
Of, involving, or connecting two or more regions: interregional migration; interregional banking. capital mobility is likely to change under a common currency is of particular relevance. The transmission channels of monetary policy, the effectiveness of fiscal policies, or the conduct of banking supervision depend on the ease with which capital can and does move across borders. This paper argues that there are essentially two forms of barriers to the free mobility of capital across regions, i.e. direct, regulatory barriers, such as branching restrictions and capital controls, and economic barriers which arise, for instance, from the costs of obtaining information about foreign markets or from fixed costs fixed costs,
n.pl the costs that do not change to meet fluctuations in enrollment or in use of services (e.g., salaries, rent, business license fees, and depreciation). in the production of financial services The examples and perspective in this article or section may not represent a worldwide view of the subject.
Please [ improve this article] or discuss the issue on the talk page. . Differences in institutional structures, which are unlikely to change in the short-run, and in preferences across countries and regions are a major factor behind these economic barriers. For Europe, the interesting question is thus to what extent economic barriers are likely to remain important even after regulatory barriers have largely been removed.
Essentially, the US are the only region which can potentially serve as a benchmark for the likely integration effects in Europe. When taking lessons from the US for Europe, however, it needs to be borne in mind that the US do not resemble the prototype of an integrated financial market Integrated financial market
A market in which there are no barriers to financial flows, and the same risk asset commands the same expected return, irrespective of domicile. either. Until quite recently, regulatory restrictions have prohibited banks in the US from freely providing financial services across (state) borders. Financial markets in Europe have undergone a similar process of deregulation Deregulation
The reduction or elimination of government power in a particular industry, usually enacted to create more competition within the industry.
Traditional areas that have been deregulated are the telephone and airline industries. as, in the 1990s, a Single Market for financial services has in principle been created. At the same time, Europe still differs from the US because its institutional structures are much more heterogeneous. If we were to find evidence for a greater degree of integration of financial markets in the US despite the fact that the regional expansion of financial institutions used to be regulated, this would point to the importance of economic barriers in the case of Europe.
Thus far, comparative evidence on the degree of financial market integration is rather scattered. Therefore, the purpose of this paper is to review the evidence on financial market integration in the US, to compare it to that from Europe, and to derive possible lessons for Europe. In the following second part, we give a brief overview of the deregulation of the banking industry in the US and in Europe. Part three provides evidence on measures of financial market integration and gives a comparative assessment of the developments in Europe and in the US. Part four derives some tentative policy conclusions for Europe, in particular for monetary policy and banking supervision. Part five concludes.
2. Deregulation of Banking Markets: Europe versus the US
Banking in the US has undergone quite significant changes over the past decades, characterized by interest rate and geographical deregulation, changes in capital requirements Capital requirements
Financing required for the operation of a business, composed of long-term and working capital plus fixed assets. , and the expansion of banking powers (Table 1).
Prior to the mid-1990s, the McFadden Act The McFadden Act is a United States federal law enacted in 1927 from recommendations made by the comptroller of the currency Henry May Dawes. The Act sought to give national banks competitive equality with state-chartered banks by letting national banks branch to the extent of 1927 had effectively restricted interstate in·ter·state
Involving, existing between, or connecting two or more states.
One of a system of highways extending between the major cities of the 48 contiguous United States.
Noun 1. branching of commercial banks; intra-state branching was limited by the so-called unit banking system that confined con·fine
v. con·fined, con·fin·ing, con·fines
1. To keep within bounds; restrict: Please confine your remarks to the issues at hand. See Synonyms at limit. banking activities to a single banking office in some states. Until 1982, interstate branching was generally forbidden. Generally, this prohibition had officially been in place until the Riegle-Neal Interstate Branching and Efficiency Act had been passed in 1994 (Rhoades 1997). Interstate privileges softened subsequently and, by 1994, almost 70 percent of banking assets were legally accessible from the average US state, an increase from less than 10 percent in the early 1970s (Berger et al. 1995). The pattern of deregulation has not been uniform across states, however. While some states had lifted barriers to the interregional activities of banks already in the early 1980s, others followed only in the 1990s. By the end of 1992, however, the process of deregulation of regional banking activities had essentially been completed (Jayaratne and Strahan 2000).
In Europe, financial market deregulation has been shaped both by the abolition of capital account restrictions and the adoption of common legislative standards. Again, the timing of implementation at the national level has varied quite substantially (European Commission (EU) 1997). Although individual countries had opted to liberalize lib·er·al·ize
v. lib·er·al·ized, lib·er·al·iz·ing, lib·er·al·iz·es
To make liberal or more liberal: "Our standards of private conduct have been greatly liberalized . . . capital flows earlier on, agreements to abolish capital controls on a European-wide level were adopted only in the 1980s (Bakker 1994). The Single European Act Single European Act
Act intended to eliminate barriers on trade and capital flows between and among European countries. , which was signed in 1986, formally established the removal of obstacles to an internal market. Full implementation into national law was achieved only in the 1990s in the majority of countries.
First steps towards leveling the playing field for financial institutions across Europe have been made in the 1970s by granting the freedom of establishment (1973) and by passing the First Banking Directive (1977). Since cross-border banking activities have remained subject to host-country supervision, the potential for national discretion has yet remained substantial. The major step towards closing the remaining gaps was made with the Second Banking Directive, which became effective in 1993. The Directive implies, among others, the acceptance of the principles of mutual recognition of banking licenses, of minimum harmonization har·mo·nize
v. har·mo·nized, har·mo·niz·ing, har·mo·niz·es
1. To bring or come into agreement or harmony. See Synonyms at agree.
2. Music To provide harmony for (a melody). , and of home country control. Furthermore, it has eliminated the need to get a local banking charter for branches in a foreign country, has subjected foreign branches to home country supervision, and has abolished the need for foreign branches to hold a certain amount of endowment capital.
Generally, the removal of restrictions to the regional expansion of banks in the US can be viewed in close relation to the creation of a Single Market in Europe. In both cases, banks have been allowed to expand their activities across borders. Although the removal of unit banking does not seem to have immediate parallels, savings and other local banks in Europe are still restricted in their regional expansion. More indirectly, the abolition of unit banking can be compared to the Single Market program, which has eased cross-border branching. Hence, a comparison of banking assets held by out-of-state financial institutions in the US and the penetration of banking markets in Europe by foreign banks can provide insights concerning the importance of "institutional" barriers to entry that still persist in Verb 1. persist in - do something repeatedly and showing no intention to stop; "We continued our research into the cause of the illness"; "The landlord persists in asking us to move"
continue Europe (see Section 3.4).
Banks in the US also used to be severely constrained con·strain
tr.v. con·strained, con·strain·ing, con·strains
1. To compel by physical, moral, or circumstantial force; oblige: felt constrained to object. See Synonyms at force.
2. in the scope of their activities as the Glass-Steagall Act of the early 1930s had imposed the separation between commercial and investment banking. After some earlier modification, the separation of commercial and investment banking activities has been lifted only in 1999. This officially widens the scope of activities of banks and the potential to exploit synergies between different banking services.
In Europe, universal banking has been permitted in a number of countries, notably Germany, throughout. With the implementation of the Second Banking Directive, it has become the standard model for all countries. This shows that lessons from financial market integration cannot only be taken from the US to Europe but also in reverse. With the abolition of the Glass-Steagall Act, Europe and the US have become more similar regarding the permitted scope of banking activities. Hence, an interesting future avenue of research would address the path dependency of financial systems and the convergence of institutional structures. (2)
At the same time, one important difference to the US is that banking supervision in Europe remains under national responsibility. Also, there is no generally accepted institutional link between banking supervision and the responsibility for monetary policy. In some countries, supervision is performed by institutions outside the central banking system, in others, the two tasks are performed under one roof. At the European level, coordination of banking supervision takes place through a banking supervision committee at the European Central Bank (ECB See electronic code book. ) which, however, serves mainly as a place for coordination and consultation.
In summary then, it is difficult to argue that deregulation of banking activities has proceeded more or less rapidly in Europe as compared to the US. While intra-European capital controls had been abolished in some countries early on, others followed only in the 1990s. In the US, there have been no formal capital controls but restrictions to the regional expansion of commercial banks have played a similar role. Weighing the severity of restrictions at any point in time would be beyond the scope of the present paper. However, the following section will argue that evidence on the degree of integration of US financial markets can provide a useful benchmark for the likely integration effects in Europe. Of course, it needs to be kept in mind that integration in the US has taken place mostly under a common currency whereas, in Europe, the sequence has been reversed. (3) Hence, the following section will also address the issue to what extent the creation of a common currency is likely to affect portfolio choices.
3. How Integrated Are Financial Markets?
Generally, restrictions to the free mobility of capital can arise from two sources. Either, governments can restrict capital flows and competition in banking by direct means such as capital controls or branching restrictions. Even if such direct barriers have been lifted, there remain substantial economic barriers to financial market integration. Asymmetries in information between domestic and foreign investors, which can arise from differences in institutional structures or in preferences, and fixed costs of market entry, can create such barriers. (4) These inherited inherited
received by inheritance.
inherited achondroplastic dwarfism
see achondroplastic dwarfism.
inherited combined immunodeficiency
see combined immune deficiency syndrome (disease). structures tend to proliferate pro·lif·er·ate
To grow or multiply by rapidly producing new tissue, parts, cells, or offspring. and to affect the way in which financial systems operate and integrate. (5)
This section is concerned with the measurement of the degree of financial market integration, mainly in the US. Although, in principle, the degree of international and of interregional capital mobility can be measured in the same way, the practical implementation of measures of capital mobility is often more difficult in a national than in an international context. This is because interest rate data or data on cross-border capital flows are often not collected on a regional basis. We therefore supplement information on interest parity tests and savings investment correlations with data on risk sharing among regions, and we provide new evidence on the impact of deregulation on cross-border banking activities.
3.1 Interest Parity Tests
In integrated financial markets, the law of one price requires that identical financial assets Financial assets
Claims on real assets. should yield the same rate of return, irrespective of irrespective of
Without consideration of; regardless of.
preposition despite where they are traded. In a domestic context, we can ignore exchange rate changes, and nominal interest parity requires simply that regional interest rates equalize e·qual·ize
v. e·qual·ized, e·qual·iz·ing, e·qual·iz·es
1. To make equal: equalized the responsibilities of the staff members.
2. To make uniform. .
Interest parity tests for the US generally show a relatively high degree of integration of wholesale markets while the evidence for retail markets is more mixed. Stigler and Sherwin (1985) calculate correlation coefficients for regional interest rates for the years 1979-1983 and find that the market for mortgage funds appears to be national in scope. Using more recent data for the years 1996-2000, Table 2 shows an almost perfect correlation between changes in regional interest rates on fixed rate mortgages while flexible short-term rates are much less correlated. Likewise, cointegration tests strongly suggested the existence of common trends in the data. (6)
However, convergence of regional interest rates over time does not necessarily imply that markets are becoming more integrated. While increased financial integration could be one possible cause, interest rate spreads in the US have also been due to differences in regional risks (Bodenhorn 1995, Eichengreen 1984). Declining interest rate differentials might thus also reflect the fact that risk characteristics have become more homogenous homogenous - homogeneous across regions.
Several studies have analyzed the degree of integration of individual market segments. Jackson (1992) looks at the transmission of interest rate shocks in different US regions and finds that the markets for money market deposit accounts and Super-NOW accounts are not national, while this seems to be the case for six-month certificates of deposits. Results of Radecki (1998, 1999) suggest that, at least for large banks, banking markets have expanded and that metropolitan areas are no longer relevant in defining relevant market segments. Heitfield (1999), to the contrary, argues that there are relatively large disparities in the interest rates charged by smaller banks. One reason for this is that smaller banks tend to service small and mid-sized customers, which have both a relatively large exposure to regional risks and are relatively opaque. The fact that close customer contacts matter in this market segment suggests, at the same time, that credit markets for these smaller firms are not national in scope.
In summary, studies on the co-movement of interest rates based on micro-data for the US lead to the conclusion that some banking markets must be defined in a relatively narrow regional sense. This might seem to be in contrast to the evidence based on macro-data which often finds evidence in favor of the interest parity condition in an international context. Clearly, this dichotomy di·chot·o·my
n. pl. di·chot·o·mies
1. Division into two usually contradictory parts or opinions: "the dichotomy of the one and the many" Louis Auchincloss. is due to differences in retail and wholesale financial markets. Whereas, in retail markets, preferences of bank customers are determined by the physical proximity to a certain bank branch, customers in wholesale markets are able to shop among different locations much more easily. Although the physical proximity between banks and their customers in retail markets tends to have increased as a response to advances in information technology (Petersen and Rajan 2000), these qualitative differences between the individual market segments are yet likely to prevail.
Evidence from Europe generally supports this view. Centeno and Mello (1999) show that money markets in Europe show a greater degree of integration than retail banking markets. As regards changes over time, Kleimeier and Sander (2000) find evidence for increased integration of financial markets in Europe, arguing that this trend appears to be a regional (i.e. European) rather than an international phenomenon.
Graph 1 and 2 furthermore provide comparative evidence on interest rate differentials between Europe and the US. Two factors complicate com·pli·cate
tr. & intr.v. com·pli·cat·ed, com·pli·cat·ing, com·pli·cates
1. To make or become complex or perplexing.
2. To twist or become twisted together.
1. this comparison. First, before the advent of the euro, differences in nominal interest rates of the members of Euroland Euroland or Eurozone
the geographical area containing the countries that have joined the European single currency
Euroland n → Eurolandia
are potentially driven by expectations of exchange rate changes. Second, regional interest rates for the US are not usually being
Graph 1: Differences in Interest Rates in Selected European Countries, 1996-2000 The graphs give the difference between national interest rates and the Euroland average rate. All data have been taken from the International Financial Statistics of the IMF, lines 60B (money market rates), 60L (deposit rates), and 60P (lending rates). The choice of countries has been guided mainly by data availability. Euro-average interest rate data have not been available prior to 1996. a) Money Market Rates [GRAPHIC OMITTED] b) Deposit Rates [GRAPHIC OMITTED] c) Lending Rates [GRAPHIC OMITTED] Graph 2: Differences in Lending Rates Across US Regions 1966-1998 The graphs give the difference between interest rates by census region and the US average. The data have kindly been provided by John C. Driscoll (see also Driscoll 1997), and have been calculated from the FDIC call reports by dividing income from loans by quantity of loans and are thus proxies for average interest rates on all outstanding loans. Only commercial banks are covered, and all types of loans (i.e. C&I loans, mortgages, and other kinds of loans) are included. [GRAPHICS OMITTED]
Hence, we are presenting evidence on interest rates which have been calculated from the balance sheets and the income statements of commercial banks. For these two reasons, one should be careful in interpreting the magnitude of interest rate differentials between countries.
Still, the graphs provide some interesting insights into differences between Europe and the US and their evolution over time. Obviously, for the members of Euroland, money market rates have almost completely been harmonized har·mo·nize
v. har·mo·nized, har·mo·niz·ing, har·mo·niz·es
1. To bring or come into agreement or harmony. See Synonyms at agree.
2. Music To provide harmony for (a melody). after 1999. The picture looks different for deposit and lending rates though. While interest rate differentials between some countries and the Euroland average have narrowed down for some countries, there has even been a process of divergence divergence
In mathematics, a differential operator applied to a three-dimensional vector-valued function. The result is a function that describes a rate of change. The divergence of a vector v is given by for others. Comparing interest rate differentials between European countries and the US census regions shows a much smaller regional disparity dis·par·i·ty
n. pl. dis·par·i·ties
1. The condition or fact of being unequal, as in age, rank, or degree; difference: "narrow the economic disparities among regions and industries" between US regional rates (notice that the scale of the graphs is much larger for Europe). This can be taken as an indication for a greater degree of integration of financial markets in the US. Even here, however, interest rate differentials are quite persistent, and, for some regions, the gap between regional and national average interest rates has even been widening in more recent years.
3.2 Saving-Investment Correlations
In integrated financial markets, not only should interest rates be identical for the same type of asset but domestic investment should also not be constrained by the supply of domestic savings (Feldstein and Horioka 1980). The degree of interregional capital mobility can thus be measured by looking at the correlation between saving and investment. Under perfect capital mobility, an increase in the saving rate in one region would cause an increase in investment in all regions. Although this is a fairly crude measure of financial integration because it does not consider the degree of integration of different market segments and because a loose correlation over time may simply reflect an intertemporal solvency constraint, it is yet indicative of the degree of integration.
The original finding of Feldstein and Horioka that national savings and investment tend to be closely correlated has been confirmed by a host of subsequent studies. Yet, studies of capital mobility on a national level tend to find lower correlations between regional savings and investment (Bayoumi 1999, Bayoumi and Rose 1993, Kellermann and Schlag 1999). In addition to redistributions by the government, asymmetries in information between domestic and foreign investors might help to rationalize ra·tion·al·ize
1. To make rational.
2. To devise self-satisfying but false or inconsistent reasons for one's behavior, especially as an unconscious defense mechanism through which irrational acts or feelings are made to appear why interregional exceeds international capital mobility.
Evidence from regional data for the US is extremely scarce. To our knowledge, the only results using the Feldstein-Horioka approach for regional US data have been presented by Sinn (1992). For the 1950s, he finds no significant correlation between regional savings and investment and notes that there are no indications to believe that interregional capital mobility in the US should have decreased since then. Most likely, the degree of interregional capital mobility in the US is thus higher than the degree of international capital mobility, including that between the members of Euroland. This is supported by the observation that current account balances between the regions of the US tend to be larger in relative terms than those found between countries (Atkeson and Bayoumi 1993). Unfortunately, evidence on the degree of capital mobility among the members of the Euroland is unavailable so far. Although Armstrong et al. (1996) find fairly low correlations between saving and investment for a cross-section of EU countries, their data do not allow a distinction between capital flows within and outside Europe and do thus not provide evidence on intra-EU capital mobility.
3.3 Degree of Regional Risk Sharing
In integrated financial markets, individuals should be able to insure themselves against unexpected changes in their income streams stemming from regional shocks by diversifying their portfolio holdings. Internationally, diversification is often found to be grossly inadequate as investors tend to have a preference for securities issued in their home country, a finding which has given rise to a debate about the possible causes of this home bias (see Tesar and Werner 1992 or Lewis 1999).
Unfortunately, for the US, data on the regional composition of asset portfolios is not available. Hence, the degree to which personal income is related to regional shocks has been used as a proxy. Atkeson and Bayoumi (1993) find that fluctuations in regional income from capital are correlated mostly with national income paid to capital rather than regional productivity shocks. This points to a relatively high degree of diversification of capital ownership. For Europe, to the contrary, the same authors find a much lower correlation of income from capital at a national and the European level. Shocks to labor income tend to have a strong regional component in both regions, and there appears to be a tendency to invest "locally" (Hess and Shin shin (shin) the prominent anterior edge of the tibia or the leg.
saber shin marked anterior convexity of the tibia, seen in congenital syphilis and in yaws. 2000).
Obviously, the introduction of the euro is likely to have had effects on (intra-EU) portfolio choices. By eliminating exchange rate risks among the members of Euroland, the euro has eliminated currency risks, and this seems to have had an impact on the structure and size of European financial markets already (Danthine et al. 2000). At the same time, many sources of the home bias such as differences in institutions and cultural differences which tend to raise the costs of assessing the profitability of investment opportunities abroad are not directly affected by the euro. Hence, to what extent the elimination of exchange rate risks and the gradual harmonization of financial market regulations that has taken place during the past couple of years in Europe have actually affected portfolio choices of investors and have reduced the home bias in investment portfolios, still remains to be seen. The fact that there is an increasing amount of empirical evidence suggesting that, even within national boundaries, investors seem to develop preferences for local securities (7) suggests that investment portfolios in Europe are likely to retain a relatively strong national flavor.
3.4 Cross-Border Banking Activities
The willingness and ability of commercial banks to provide their services across (state) borders is an important indicator for the openness of a financial market. Generally, it could be expected that US banks have been able to seize market opportunities that have opened up through geographic deregulation more quickly than this would have been the case in an international setting. Berger et al. (1995) indeed report a significant impact of the abolition of branching restrictions on cross-state-border banking activities. Whereas, in 1979, financial assets controlled by out-of-state holding companies stood at 2.1 percent of the total, this share had increased to 27.9 percent already by 1994. In Europe, to the contrary, market shares of foreign branches and subsidiaries from other European countries were still substantially below this value for nine out of 14 EU countries in 1997 (including those hosting financial centers) (ECB 2000). Although these figures are not immediately comparable, (8) they yet tend to show a greater degree of market penetration Noun 1. market penetration - the extent to which a product is recognized and bought by customers in a particular market
penetration - the act of entering into or through something; "the penetration of upper management by women" by out-of-state banks in the US as compared to Europe.
In the US, the number of banks operating in different states has also increased rapidly from about 100 to over 400 between 1984 and 1999 (Graph 3). Over the same period, the share of these banks in total banking assets has increased from 30 to over 60 percent, their share in total deposits being somewhat lower. Presumably pre·sum·a·ble
That can be presumed or taken for granted; reasonable as a supposition: presumable causes of the disaster. , these lower market shares in the deposit business reflect the comparative disadvantage of new market entrants in retail banking and their lack of access to a branch network.
[GRAPHIC 3 OMITTED]
Geographical deregulation has also been one of the major factors driving consolidation of the US banking industry. Although, initially, consolidation of the industry had taken place on a state level (Berger et al. 1995), banks have then started to form cross-border alliances. Generally, the major mode of entry into new markets have been cross-border acquisitions rather than greenfield Greenfield, town (1990 pop. 18,666), seat of Franklin co., NW Mass., at the confluence of the Deerfield and Green rivers, near their junction with the Connecticut; settled 1686, set off from Deerfield and inc. 1753. investments (Cecchetti 1999). At the same time, the regional expansion of banks has been less rapid than one might have had expected. The proportion of loans granted by out-of-state lenders, for instance, has been only 7 percent on average in 1996 (Cyrnak and Hannan 1999). Also, banks had not made full use of the opportunities of inter-state branching: while the share of national assets legally accessible from a typical US state had gone up from 6.5 to 69.4 percent between 1979 and 1994 (Berger et al. 1995), the share of actual cross-border asset holdings stood only at about 30 percent at the end of the period.
In the Appendix, we provide empirical evidence that the liberalization lib·er·al·ize
v. lib·er·al·ized, lib·er·al·iz·ing, lib·er·al·iz·es
To make liberal or more liberal: "Our standards of private conduct have been greatly liberalized . . . of intra-state branching has in fact had a positive and statistically significant impact on the change in the market shares of out-of-state financial institutions, even after controlling for other factors such as market size or the size of the state's financial sector (see also Table A3). When taking implications from these results to Europe, however, it should be borne in mind that the borders between US states are and have been less important for banking activities than borders between European countries. While, historically, branching restrictions have indeed limited interstate branching, other regulatory and institutional differences have been much less pronounced than they are in Europe to date. Hence, when branching restrictions have been lifted, banks in the US could reap the new opportunities that opened up to them much faster.
4. Lessons for Europe?
Essentially, two stylized facts In social sciences, especially economics, a stylized fact is a simplified presentation of an empirical finding. While results in statistics can only be shown to be highly probable, in a stylized fact, they are presented as true. characterize financial markets in the US and in Europe. First, the degree of capital mobility among the regions of the US tends to exceed that among the members of Euroland. A greater degree of homogeneity Homogeneity
The degree to which items are similar. of institutional structures and greater cultural homogeneity are likely to reduce barriers to the free flow of capital in the US. Second, even in the US, regional banking markets show a considerable degree of segmentation, especially when it comes to retail banking. Information costs Information costs
Transactions costs that include the assessment of the investment merits of a financial asset. Related: Search costs. and fixed costs of market entry thus tend to limit competition through new market entrants. The degree of interregional capital mobility has, at the same time, implications for economic policy. In the following, we will focus on monetary policy and banking supervision.
4.1 Monetary Policy
In segmented financial markets, a common monetary policy can have differential regional effects stemming from two sources. First, differences in the financing sources of firms and thus in financial market structures affect the transmission of monetary impulses (Dornbusch et al. 1998). Hence, it would be of interest to compare the degree of regional disparity of financial structures in the US to that of Europe. Unfortunately, such data on a regional basis are not available for the US. The fact that regional institutional conditions are more heterogeneous in Europe than in the US, however, would imply that financial structures also show a greater degree of diversity (Cecchetti 1999). Second, the degree of interregional capital mobility affects regional liquidity conditions. Since interregional capital mobility in the US is higher than in Euroland, regional effects of monetary policy should be less pronounced in the US than in Europe.
Empirically, it is difficult to discern dis·cern
v. dis·cerned, dis·cern·ing, dis·cerns
1. To perceive with the eyes or intellect; detect.
2. To recognize or comprehend mentally.
3. whether regional effects of monetary policy are due to differences in transmission mechanisms, in the degree of capital mobility, in regional industrial structures, or a combination of these. Nevertheless, there are a number of studies for the US which show different regional responses to common monetary policy shocks.
From a historical perspective, Rockoff (2000) argues that regional shocks have been severe in the early stages of a common currency, and that these shocks have caused banking sector instabilities and balance of payments difficulties. He concludes that a stable financial system has evolved only after a particular set of institutions had been adopted in the US in the 1930s, including a system of intra-regional fiscal transfers, a lender of last resort Lender of Last Resort
An institution, usually a country's central bank, that offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse. In the U.S. facility, and a common deposit insurance system. More recent empirical evidence shows that monetary policy in the US does still not have homogenous effects across regions (Bias 1992, Carlino and DeFina 1998, Driscoll 1997). Apart from industry mix, differences in financial systems and thus structures of financial resources are one factor behind these differences.
Differences in institutional structures and the resulting asymmetries in information are thus likely to affect monetary policy in Euroland in two regards. First, the fact that institutions converge only slowly and that different financial systems are likely to coexist co·ex·ist
intr.v. co·ex·ist·ed, co·ex·ist·ing, co·ex·ists
1. To exist together, at the same time, or in the same place.
2. for the years to come implies that the transmission of monetary impulses will differ across European countries. Ceteris paribus Ceteris Paribus
Latin phrase that translates approximately to "holding other things constant" and is usually rendered in English as "all other things being equal". In economics and finance, the term is used as a shorthand for indicating the effect of one economic variable on this renders the prediction of the effects of monetary policy more difficult than in a more homogenous currency union and adds to pressure stemming from product markets due to asymmetric A difference between two opposing modes. It typically refers to a speed disparity. For example, in asymmetric operations, it takes longer to compress and encrypt data than to decompress and decrypt it. Contrast with symmetric. See asymmetric compression and public key cryptography. shocks. This conclusion is supported by Carlino and DeFina (1998) who show that the speed of adjustments to monetary shocks differs across Europe.
Second, asymmetries in information prevent the free flow of capital between the members of Euroland particularly because credit markets are less-than-perfectly integrated than in a single country. This, in turn, potentially aggravates the effects of regional liquidity shocks (see also Freixas and Holthausen 1999). Monetary policy might thus face the problem that liquidity conditions evolve quite heterogenously in Euroland.
4.2 Banking Supervision
Deregulation and the geographical expansion of banks' activities potentially increase competitive pressure on the incumbent financial institutions. This might affect the profitability and the riskiness of banks and put additional requirements on banking supervision.
From a theoretical point of view, however, the impact of greater market integration on banking sector profitability and stability is undetermined. On the one hand, market integration allows banks to expand regionally and to become less exposed to regional shocks. This, ceteris paribus, should enhance the stability of the banking sector. On the other hand, changes in the competitive structure of the banking system have consequences for the risk-taking behavior of commercial banks. Increased competitive pressure from non-bank financial intermediaries Financial intermediaries
institution that provide the market function of matching borrowers and lenders or traders. , for instance, might force banks to increase the share of lending towards relatively risky small and mid-sized firms (Boot and Thakor 1997a, 1997b). In addition, the integration of financial markets tends to put downward pressure on interest rate spreads and might lower the monitoring incentives of banks (Aizenman 1998, Gehrig 1998).
An empirical analysis of these processes thus has to answer three questions. First, has competition increased due to the deregulation of the banking industry? Second, has this been associated with a decline in interest rate spreads and profits? Third, has the riskiness of banks increased?
Simple descriptive statistics descriptive statistics
see statistics. for the US do not provide an affirmative answer to the last two questions (Graph 4). Over the past 20 years, profits and net interest income of banks in the US have, if anything, increased, and net provisions have eventually come down to the levels observed in the late 1970s.
[GRAPHIC 4 OMITTED]
A number of empirical studies Empirical studies in social sciences are when the research ends are based on evidence and not just theory. This is done to comply with the scientific method that asserts the objective discovery of knowledge based on verifiable facts of evidence. do indeed show that the profitability of banks in the US has not declined in response to deregulation. Berger et al. (1999) find that profit persistence has even increased over the past three decades. Their results indicate that the removal of geographic branching restrictions did not affect the competitiveness of the banking industry, and that banking sector performance has remained sensitive to local, state, and regional shocks. Work by Rose (1999), who finds that the interregional expansion of banks seems not to have weakened the earnings position of locally-oriented banks, and of Cyrnak and Hannan (1999), who show that market penetration by out-of-state banks did not tend to lower loan rates, is consistent with this result. Other studies find greater evidence for the hypothesis that deregulation has reduced local market power (see, e.g., Calam and Nakamura 1998).
Still, even if we were to find a positive link between deregulation and profitability, it needs to be disentangled whether this is the result of changes in competition, changes in efficiency, or a combination of these. This is because the fact that increased concentration following deregulation is often found to be correlated positively with profitability has two possible interpretations. The positive link may imply increased market power and thus a decline in competitive pressure (structure-performance hypothesis). It is equally conceivable con·ceive
v. con·ceived, con·ceiv·ing, con·ceives
1. To become pregnant with (offspring).
2. , however, that a positive link between concentration and profitability is the result of increased efficiency (efficient-structure hypothesis) and thus of increased competitive pressure. The empirical evidence on this is mixed. While Berger and Hannan (1989) as well as Cyrnak and Hannan (1999) find support for the structure-performance hypothesis, results of Radecki (1999) suggest that effects of increased market power and of increased efficiency have tended to cancel out Verb 1. cancel out - wipe out the effect of something; "The new tax effectively cancels out my raise"; "The `A' will cancel out the `C' on your record"
wipe out .
Overall, these results suggest that, although deregulation has increased the incentives of banks to expand across borders, the impact on the profitability of the US banking system seems to have been modest. Two interpretations, which are not mutually exclusive Adj. 1. mutually exclusive - unable to be both true at the same time
incompatible - not compatible; "incompatible personalities"; "incompatible colors" , are conceivable. On the one hand, superior risk management, facilitated by improved possibilities of regional diversification and improved technologies may have tended to enhance the stability of the US banking system. On the other hand, market power derived from intimate knowledge of smaller customers, of local market conditions, and from existing customer contacts has partially shielded banks from competitive pressure. A recent study by Jayaratne and Strahan (2000) essentially confirms this view. They find that the relaxation of entry restrictions has increased bank efficiency and decreased banking sector instability. Although market concentration at local levels has remained relatively unaffected, market power seems not to have increased.
Of course, the key question is to what extent these outcomes can be generalized. Evidence from a number of developed and developing countries has shown that the deregulation of financial markets has tended to increase instabilities and may even have been the trigger of severe financial crises. However, the experience of these countries differs from the deregulation periods considered here for a number of reasons. Most importantly Adv. 1. most importantly - above and beyond all other consideration; "above all, you must be independent"
above all, most especially , the financial systems of these countries have often been severely financially repressed re·pressed
Being subjected to or characterized by repression. prior to deregulation, and government involvement in the financial sector has often been substantial. Also, monetary and fiscal stabilization policies have in many cases been implemented in parallel to financial liberalization programs. It would thus be both premature and misleading to use the experience from the US and to draw the conclusion that deregulation stabilizes rather than destabilizes financial systems.
Moreover, stylized facts on banking performance in the US and in Europe suggest that deregulation has had different effects in the two regions (Graph 4). While banks in the US and in Europe reported similar rates of return on assets Return on assets (ROA)
Indicator of profitability. Determined by dividing net income for the past 12 months by total average assets. Result is shown as a percentage. ROA can be decomposed into return on sales (net income/sales) multiplied by asset utilization (sales/assets). at the beginning of the 1990s, profitability of banks in Europe declined somewhat while it increased substantially in the US. Differences in net interest income relative to assets have been persistent with relatively little variation over time between the regions. Finally, although provisioning expenses stood at similar levels in the 1990s and have declined in both regions, the overall decline has been larger in the US (ECB 2000).
Despite these differences, one lesson that can be taken from the US is that the effects of deregulation and integration are rather difficult to pin down, and that different market segments are likely to be affected to different degrees. There is, for instance, evidence that the impact of increased competition differs between rural and urban markets in the US in the sense that entry has had a more significant effect on profit rates in rural markets (Amel and Liang 1997). Differences in the regional pattern of bank solvency and liquidity can thus have a bearing on banking sector stability and should be a concern of banking supervision. Even if financial integration might not always and everywhere increase risk taking and lower the profitability of banks, the opposite does not hold true either. Hence, banking regulations must take account of the fact that regional shocks will remain pervasive. This might require a closer coordination of banking supervision and a more unified framework than the one currently in place in Europe. Although a coordinating council for national banking supervisors has been established, this diversity in institutional structures might cause decision and information lags in situations in which prompt action would be needed.
Both, Europe and the US, have experienced substantial changes in the structure of their financial systems, and regional financial markets have tended to become more integrated. This paper has argued that it is difficult to assess whether regulatory restrictions to (full) capital mobility such as branching restrictions and capital controls have been more or less important in the US than in Europe recently. Obviously, the main difference between the two regions is the fact that, in the US, financial integration has taken place within the context of a political union, of more homogenous institutional structures, and under a common currency. While restrictions to the full integration of financial markets due to exchange rate risks have been eliminated also in Europe through the introduction of the euro, differences in institutions yet proliferate. Finding evidence for a greater degree of financial integration in the US can thus be taken as one piece of evidence for the role institutional differences are playing in separating financial markets in Europe.
Empirically, it is difficult to isolate regulatory barriers to capital mobility from those inherent in the structure of financial markets, stemming from differences in institutions, preferences, or from information costs. Evidence from the US shows that particularly retail markets feature quite significant economic barriers to entry. While banks have expanded relatively quickly after geographical deregulation, the scale of their regional expansion seems to have been restricted nevertheless. Essentially, the evidence from the US confirms that retail banking is a local business. This is also evidenced by the fact that consolidation has first taken place on a state-level which, in turn, parallels developments in Europe. Following the Second Banking Directive and the creation of the Single Market, merger activity has been decidedly more pronounced on a domestic level than internationally. In wholesale banking, to the contrary, location-specific factors seem to be less important.
As regards links between deregulation and the stability of the financial system, there is relatively little evidence that financial integration induces risk-taking and lowers bank profitability. One major factor contributing to this is the local nature of retail banking activities, in addition to improvements in the efficiency of banks. At the same time, it is precisely the fact that regional liquidity and solvency conditions might differ even in a currency union if regional shocks remain important which may have implications for banking supervision.
Obviously, one important caveat to the extrapolation (mathematics, algorithm) extrapolation - A mathematical procedure which estimates values of a function for certain desired inputs given values for known inputs.
If the desired input is outside the range of the known values this is called extrapolation, if it is inside then of past trends are the dynamic changes taking place in the financial services industry to date, in particular the increased use of electronic banking services. Especially in the retail banking business, e-banking has the potential to loosen traditional customers links. To the extent that preferences for local banks arise from superior information available to local branches, which might not be easily transmittable via the internet, however, banking will nevertheless stay local.
Deregulation and Cross-Border Banking
To show the link between regional deregulation and cross-state-border activities of banks, a panel dataset for 51 states for the years 1982-1994 has been used. The share of banking assets held by out-of-state financial institutions in total assets has been regressed on a number of explanatory variables such as log of real GDP GDP (guanosine diphosphate): see guanine. , total banking assets in relation to GDP, a dummy variable This article is not about "dummy variables" as that term is usually understood in mathematics. See free variables and bound variables.
In regression analysis, a dummy variable capturing the deregulation of banking activities, and a dummy variable capturing the share of assets accessible from a given state. Since the US states have lifted barriers to the cross-state-border expansion of banks at different points in time, there is quite some cross-section variation in the liberalization dummy Sham; make-believe; pretended; imitation. Person who serves in place of another, or who serves until the proper person is named or available to take his place (e.g., dummy corporate directors; dummy owners of real estate). .
In order to take account of the potential non-stationarity of the dependent variable, we have implemented the two-stage Engle Granger cointegration test (Engle and Granger 1987). For this purpose, the following equation has been estimated to generate the long-run coefficients:
(1) [y.sub.it] = [[alpha].sub.i] + [[beta]x.sub.it] + [[epsilon].sub.it]
where [y.sub.it] share of state financial assets in state i controlled by out-of-state financial institutions, [x.sub.it] = time-varying explanatory variables, and [[epsilon].sub.it] = error term. The residuals from estimating (1) were then tested for stationarity by means of panel unit root tests. Results from these equations show a positive impact of the log of real GDP (elasticity of about +0.36) and a negative impact of population size (-0.37) (Table Al). The size of a state's financial system is highly significant, an increase by one percentage point raising the share of out-of-state financial institutions almost proportionally (+0.98). The liberalization of intra-state banking activities enters with a positive and significant sign although the economic significance of this effect is relatively small (+0.06). Generally, these results suggest that deregulation has increased interstate banking competition.
This negative sign on population is somewhat difficult to rationalize since one would expect that more populous pop·u·lous
Containing many people or inhabitants; having a large population.
[Middle English, from Latin popul states are more, not less, attractive destinations for out-of-state banks. Similarly, a negative coefficient was found when population density was used as an explanatory variable. However, dropping either of these variables leaves our main result, i.e. the positive impact of deregulation on cross-border asset holdings, unaffected.
Since one of the tests rejected the hypothesis that the residuals of this equation are stationary, we have additionally estimated the equation in first differences. Again, the result is similar: GDP and the size of the financial system enter with a positive, population size with a negative sign. Liberalization of intra-state branching has again a positive impact on the change in the market shares of out-of-state financial institutions.
Table A1: Determinants of the Share of Banking Assets Held by Out-of-State Financial Institutions in US States (1982-1994) Dependent variable Explanatory variables share_in d (share_in) log real GDP 0.48 *** (13.98) dlog real GDP 0.21 *** (2.85) log population -0.46 *** -0.00 ** (-14.87) (-2.02) liberalization dummy 0.06 *** 0.02 *** -5.18 (4.55) asset share 1.11 *** (14.67) d (asset share) 0.29 * (2.06) [R.sup.2] 0.82 0.10 Number of observations 663 612 Durbin Watson 0.66 1.96 Stationarity tests Levin and Lin (1993) -4.35 ** modified Levin/Lin -4.37 ** Im, Pesaran, and Shin (1997) -1.26 t-values in brackets, ***(**,*) = significant at the 1 (5, 10) percent level. Fixed effects estimates. Definitions and data sources: asset share = total banking system assets over GDP liberalization dummy = year of first removal of interstate barriers (Berger et al. 1995) real GDP = total gross state product: real GSP (millions of chained 1992 dollars), Bureau of Economic Analysis, http://www.bea.doc.gov/ bea/regional/data.htm population = population size share_in = proportion of state gross domestic assets controlled by out-of-state MBHCs (Berger et al. 1995, Table A7) Source: Own calculations. Table 1: Deregulation of Financial Markets 1970s 1980s 1990s Europe Common currency Abolition of capital controls Creation of a Single Market First Banking Second Directive Banking Directive US Common currency Lifting of interstate Riegle-Neal branching restrictions Act Lifting of interest rate ceilings Abolition of Glass Steagall Act Not implemented in Partial implementation Full implementation most countries or regions Source: Bakker (1994), EU (1997), Santomero and Babbel (1997), author's presentation. Table 2: Correlations Coefficients for Monthly Changes in Regional Mortgage Rates 1996-2000 North- Southeast central Northeast Southwest West Adjustable Rate Mortgages, 1 year, 6:1996-2:2000 Southeast 1.00 Northcentral 0.34 * 1.00 Northeast 0.34 * 0.25 1.00 Southwest 0.45 * 0.43 * 0.33 * 1.00 West 0.15 * 0.33 * 0.34 * 0.31 * 1.00 Fixed Rate Mortgages, 15 years, 2:1996-2:2000 Southeast 1.00 Northcentral 0.92 * 1.00 * Northeast 0.90 * 0.91 * 1.00 Southwest 0.91 * 0.92 * 0.89 * 1.00 West 0.89 * 0.92 * 0.88 * 0.92 * 1.00 Fixed Rate Mortgages, 30 years, 2:1996-2:2000 Southeast 1.00 Northcentral 0.96 * 1.00 Northeast 0.91 * 0.91 * 1.00 Southwest 0.95 * 0.95 * 0.90 * 1.00 West 0.93 * 0.94 * 0.90 * 0.95 * 1.00 * = significant at the 5% level of confidence. Source: Freddie Mac's Survey, commitment rates, retrieved via Datastrem own calculations.
(1.) On the implications of the euro see references quoted in Cecchetti (1999) or Danthine et al. (2000).
(2.) Boyd and Gertler (1995) as well as Schmidt et al. (1999) provide evidence on the degree of disintermediation The elimination of the distributor and/or retailer (the middleman) when making a purchase. The term is used to refer to purchasing directly from a manufacturer's Web site, the benefits of which are convenience, fast turnaround time and sometimes lower prices. of financial services in the US and in Europe.
(3.) Note, however, that even the US did not have a single currency until the early twentieth century (Kim 1997).
(4.) See Gehrig (1993), Gordon and Bovenberg (1996), or Montgomery (1990) for models showing the impact of information costs on capital mobility.
(5.) Evidence presented in La Porta et al. (2000), for instance, suggests that the degree of government ownership in banking is related to the structure of the legal system.
(6.) Results are obtainable from the author upon request.
(7.) Such a "home bias at home" is reported by Coval and Moskowitz (1999) for the United States United States, officially United States of America, republic (2005 est. pop. 295,734,000), 3,539,227 sq mi (9,166,598 sq km), North America. The United States is the world's third largest country in population and the fourth largest country in area. and Grinblatt and Keloharju (2000) for Finland.
(8.) Data for the US may, for instance, include asset holdings of foreign rather than out-of-state US banks. Also, there is a substantial regional variation of these figures across the US states.
(9.) See Table 3 for details.
(10.) Also, three of the explanatory variables were found to be non-stationary.
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* This research has been conducted during a research visit at the National Bureau of Economic Research, Cambridge MA. Financial support of the Volkswagen Foundation and the hospitality of the NBER are gratefully acknowledged. The author would like to thank John C. Driscoll, Stefan M. Golder, Ralph P. Heinrich as well as an anonymous referee for most helpful comments on an earlier draft and John C. Driscoll for kindly sharing his data on regional interest rates in the US. Lusine Lusinyan and Marco Oestmann have provided most efficient research assistance. All errors and inaccuracies are solely in my own responsibility.
Claudia M. Buch Kiel Institute of World Economics