Is financial integration in Europe good for growth and stability?
Earlier this week, I participated in a panel discussion on Does Financial Integration hold the key to European Stability and Growth? in London. The discussion was organised by the Chatham House, so the well-known rule applies, but I can certainly report my own thoughts. The question is stated somewhat provocative. There is certainly not one specific policy or reform that holds the key to European stability and growth, but financial integration can certainty contribute. How?
First, there is an expansive literature that shows that more efficient financial systems can support economic growth. While most of this evidence shows the biggest economic effect for emerging markets and non-linearities (i.e., smaller, if not insignificant effects at higher levels of financial and economic development), there are also important effects stemming from financial structure, as shown by several papers, but most prominently and directly applied to Europe by Langfield and Pagano (2016): the bank-bias in Europe’s financial system explains the lower growth and the higher fragility in Europe’s economies compared to other advanced economies. Building up non-bank segments in Europe’s financial system is thus critical to achieve higher growth and higher stability. In a recent paper, I show with several co-authors that banks’ liquidity creation helps foster economic growth only through tangible but not intangible investment; as economies shift their sectoral and asset composition towards intangible capital (both within and across sectors), the growth effect of banking sector development turns insignificant. Finally, Ralph De Haas and Alex Popov (2023) show that more market-based financial systems are better positioned to support economies’ transition to net zero. So, strengthening the non-bank, market-based segment of the financial system would allow Europe to better exploit benefits of the new economy and progress faster towards net zero.
Second, public financial markets are more than other segments of the financial markets reliant on scale and network effects, i.e., the more participants on both sides (investors and listed securities), the higher the liquidity and thus benefit for economic growth. We show this effect in a recent paper on nascent stock exchanges. However, this scale effect is not limited to public financial markets; venture capitalists and equity funds depend on exit options through public markets; institutional investors, including insurance companies, pension funds and other investment funds, rely on deep and liquid markets. Looking at Europe, financial markets are fragmented, which holds back their development but also that of other critical non-bank segments of the financial system.
Third, strengthening market-based finance in Europe through integration does not imply that one should ignore the bank-side of Europe’s financial system. Rather, there are important feedback effects between banking sector and financial market integration. Larger and cross-border European banks allow a stronger role for them in investment banking and thus market development. Developing European safe assets helps both banking sector integration (including by cutting the bank-sovereign vicious cycle) and deepen financial markets. Deeper financial markets allow banks more effective securitisation and, more generally, raising funds beyond deposits. So, it is not banks versus market, but banks and markets that we care about for financial integration.
20. March 2025
The bright side of regulatory arbitrage
Banks might shift assets and risk across countries due to differences in regulatory regimes. In a recently published paper, Consuelo Silva-Buston, Wolf Wagner and I show that cross-border supervisory cooperation agreements can also result in such regulatory arbitrage with risks being shifted into a third country. In a new working paper, we consider the real effects of such regulatory arbitrage. On the one hand, countries with weaker regulatory standards may receive capital inflows that allow firms to borrow more, potentially alleviating financial constraints This may be particularly beneficial if countries with less developed financial systems (and hence more constrained firms) are also countries with relatively lower regulatory standards.2 On the other hand, such benefits are conditional on whether the additional lending is targeted towards well-managed, efficient, and profitable firms, as a purely risk-motivated reallocation might result in negative NPV projects being funded. Regulatory arbitrage can thus also lead to excessive risk-taking and misallocation of resources.
We use the syndicated loan market as a laboratory to explore the effect of regulatory arbitrage on lending terms, as well as firm behaviour and performance. We first show that a subsidiary of a bank group extends larger loans to firms when the extent to which cooperation covers the group’s global operations (excluding the subsidiary country itself) increases (for example, as a result of the parent country of the group forming a cooperation agreement with another country in which the group has subsidiaries). We also consider the effect on loan pricing and find that when cooperation elsewhere increases, the subsidiary also offers lower lending rates to firms. Thus, lending conditions improve on both the quantity and price margin.
We next investigate which types of firms benefit from the improvement in lending conditions. Our results suggest that the firms that benefit most from improved lending conditions are high-quality firms that are less likely to fail) and firms with which the bank is less at an informational disadvantage (in our case: because it has an existing relationship with the firm). This is consistent with the the literature on foreign entry has shown that foreign banks often face a disadvantage in making new loans compared to incumbent local banks, because of inferior access to local information.
Finally, we consider whether there are real benefits arising from the shift in lending conditions. Exploiting the same third-country variation in relative supervisory stringency, we show that firms that borrow from banks that receive positive shocks in third-country supervisory cooperation expand their activities. They increase their asset base, have higher capital expenditures, and do more R&D. These firms also see their profits increase. This is consistent with financing constraints being eased at such firms.
Overall, this points towards positive real effects arising from regulatory arbitrage. In particular, the fact that the additional lending seems targeted towards high-quality and safe firms, coupled with the fact that financial constraints are likely to be tighter in countries with weaker supervisory standards (and hence the ones receiving the inflows), allows for the possibility that a reallocation of lending between countries on net alleviates financial constraints, resulting in more desirable projects being funded. This is by no means to claim that regulatory arbitrage overall is desirable. Rather, our results suggest that there are likely to be trade-offs between additional lending and financial stability. It also points to the possibility that the distribution of benefits and costs of regulatory arbitrage are not necessarily equally distributed across countries. In particular, countries may benefit from relatively weaker regulatory standards as that stimulates the domestic economy through higher lending. This may explain the persistence of significant differences in regulatory standards across countries and the fairly low degree to which countries cooperate in the supervision of their banks.
17. March 2025
Reasons to be optimistic for Europe
The breath-taking realignment of the current US Administration away from democratic Europe towards autocratic Russia, the lack of European leadership, including a gap in German leadership, and a stagnant European economy give lots of reasons to be gloomy about Europe’s future. However, there are also reasons to be optimistic.
One, not only have the German elections provided the clear option of a two-party government (though I would have preferred the Green party to be the second party), but the new partners have moved forward quickly, acknowledging that unprecedented times call for quick reactions by a functioning government. The previous black-red coalitions (they used to be called Grand Coalitions at a time when they combined more than two thirds of seat in the Bundestag, a time which looks far away in the past) under Angela Merkel are for me synonymous with expansion of the social welfare state and reform stagnation, neglect of infrastructure and geopolitical realities; Germany benefitted from cheap Russian oil, a booming Chinese market for German exports, the US security umbrella and its anchor role in the euro area. Except for the last, all of these are gone, so this black-red coalition has to make a break with the past; at least for the chancellor—to-be, Friedrich Merz, not as much a problem given that he was a critic of Merkel. And it seems that both parties are willing to make a break, starting with the economically damaging constitutional debt brake. Obviously, it is not just about spending lots of more money, but investing wisely, in infrastructure and in defence. But the change in the fiscal stance can also have shorter-term positive effects on both German and European economies, something we need urgently.
Two, the UK Prime Minister Keir Starmer has grown in his role and moved towards partly filling the European leadership gap in defence. Not being burdened by the bad relationships between Tories and European partners due to Brexit, the UK has the chance to take again its natural role in Europe, at least when it comes to defending European values and interests. The first time since 2010 that a British Prime Minister looks truly prime ministerial.
Three, European leaders have accepted the challenge and are coordinating a response. It remains to be seen how far the initial willingness will take us and it is clear that unanimous decision-taking in the European Union is being impeded by certain Central European governments. New forms of cooperation (e.g., involving the UK) have to be found. At the same time as Europe has to ascertain its geopolitical clout, the relationship with US has to be managed carefully, given the current dependence of European armies on US weapons and military equipment. The build-up of a European defence industry, however, is critical. At the same time, a more hard-nosed approach, without losing the moral compass, is needed for European foreign policy.
Finally, the Trumpian America First approach has put its populist and right-wing allies across Europe on the back foot, at least for the moment. The example of Canada, where Trump’s erratic and offensive attitude helped revive the chances of the Liberal Party is telling! The Trumpian threat against democratic Europe, economically, politically and socially, has energised the democratic centre! Let’s hope it is not just a short-term sugar boost.
11. March 2025
AI and Financial Stability
Artificial intelligence has been described as major game changer, for economies and societies, including for the financial system. And there are certainly lots of opportunities for improving efficiency in financial service provision, for example in investment advice (robo advisors), algorithmic trading and loan application screening. It can also help on the regulatory side, for example in the detection of fraud and money laundering
It is important to understand that AI relies on past data and is certainly less efficient when it comes to completely new situations when it cannot rely on past data and relationships. Further, AI focuses on narrow optimisation problems and does not have an understanding of the broader environment in which humans operate and interact. Both characteristics are an important difference between human and artificial intelligence. This does not take away from the usefulness of AI, however, puts important limitations on its use.
However, there are certainly also risks for financial stability. And that is what I focused on in a recent panel discussion on AI at the Warwick Economics Summit. One such risk is stronger procyclicality in lending, given the data-reliant approach of AI (similar to transactions vs. relationship lending). This might become worse during highly uncertain times (think pandemic shock) when reliance on previous experience is all but impossible. Another risk is that of herding, given model conformity and high correlation of algorithmic traders. This can exacerbate market swings and result in mispricing of risk. There is also the risk of susceptibility to malicious attacks by maliciously modifying the AI model. And it is important to remember that when better risk management tools are available, there is the tendency to also take more risks, which in turn increases the risk of financial fragility. AI might result in an illusion of control that is not really there!
There are concerns beyond stability, related to data privacy; given the reliance of AI on data, concerns on data leakages and breach of confidentiality cannot be ignored. Ultimately, this can result in an increasing segment of the population deciding to opt out of the financial system, refusing to share their data; an endogenous digital divide.
In sum, as many previous innovations, AI has a bright and a dark side to it and has to be used with caution. Having listened both to strong advocates and critics of an increasing role of AI in finance, there is one thing that both group seem to agree on: the need for a strong human oversight. And an increasing use of AI in finance certainly requires an adjustment in regulation and supervision of financial institutions, including for macroprudential authorities.
Some interesting references
Buckman, Haldane and Hueser (2021): Comparing minds and machines: implications for financial stability. Staff Working Paper 937, Bank of England
Shabsigh and Boukherouaa (2023): Generative Artificial Intelligence in Finance: Risk Considerations. Fintech Note 2023/006. IMF
And a very recent eBook, published by the Florence School of Banking and Finance: Digital finance in the EU : Navigating new technological trends and the AI revolution.
8 March 2025
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