What is it good for? Absolutely for financial integration

Elias Papaioannou, Sebnem Kalemli-Ozcan, José-Luis Peydró, 20 June 2009



The introduction of the euro has been one of the most important policy experiments in the international arena. In the early 1990s, when the initial stages of the Economic and Monetary Union were designed and implemented, a fierce debate emerged between euro-optimists and euro-sceptics. The former group believed that the euro would be good for “everything,” which makes it the necessary ingredient for the completion of the single market (see the Delors Report). The latter group emphasised that the European economy lacked the necessary pre-conditions for becoming an optimal currency area (Mundell, 1961).

At the tenth anniversary of the euro, do we know what the euro is good for? There has been extensive research that tries to quantify the impact of the euro on trade, conduct of monetary policy, and financial integration.1 Although researchers generally find positive effects of the euro on these various outcomes, the usual identification problem remains. The main issue here is that there have been numerous policy changes and reforms coinciding with the introduction of the euro, so it is difficult to distinguish the direct impact of the euro on any outcome.

In recent research (Kalemli-Ozcan, Papaioannou, and Peydró, 2009a), we try to identify the impact of the euro on financial integration. It is important to know whether the euro has an impact on financial integration, and if so, its size and causal mechanism. The answers to all these questions are important for a number of policy reasons. First, the euro may enhance total welfare of firms and households through financial deepening by allowing consumption smoothing, enabling risk sharing, and promoting long-standing productivity growth. Second, the international role of the single currency and its global role vis-à-vis the dollar strongly depend on the ability of the euro area countries to develop deep and liquid financial markets. Third, financial integration may in turn promote international specialisation and enable countries to reap benefits from enhanced productivity as a result.

One advantage of our empirical analysis over the existing literature comes from our utilisation of a rich confidential panel data set on bilateral financial linkages. Our data cover the past three decades and thus, we have significant “before euro” and “after euro” observations and variation. This data set not only helps us better identify the euro’s impact on financial integration, it also allows us to investigate the exact channels through which the euro affects financial integration. Specifically, we explore the effect of three such channels:

  • elimination of the exchange-rate risk among the euro area economies,
  • simultaneous legal-regulatory reforms in financial sector, and
  • increased trade volume as a result of the euro.

We find that the euro’s positive impact on financial integration works mainly through the elimination of the currency risk. Yet, legal harmonisations in banking, capital markets, and insurance have also spurred cross-border financial activities among the euro area nations, an issue not previously investigated in the literature.

What do we know and do not know on the euro’s effect on financial integration?

Following the development of new datasets on cross-border investment (such as the IMF’s Coordinated Portfolio Investment Survey), recent research has examined the impact of the euro on various forms of financial integration (see Lane 2008 for a review).2 This body of research offers evidence that financial integration among the euro area countries is significantly higher compared to other country pairs. In fact, evidence so far points out to an extremely large effect – around 200%-300% – that a priori looks quite unrealistic. This is mainly because the short time spans of the available data forces researcher to employ cross-sectional approaches that compare integration across pairs of countries. However with a cross-sectional approach, it is hard to account for the effect of country-pair time-invariant factors, such as trust, cultural ties, and geographic distance that crucially affect financial integration (e.g. Ekinci, Kalemli-Ozcan, and Sorensen 2008; Portes and Rey 2005; Guiso, Sapienza, and Zingales 2009). In addition without enough time observations “before” and “after” the euro, it is hard to separate the effect of the euro from other reforms and global trends. Both of these issues might explain the inflated estimates. While previous research acknowledged these limitations and to some extent tried to circumvent them, the bottom line is that, due to all these confounding factors, we still do not know the magnitude of the euro’s impact on cross-border financial integration.3

Another important open question is that we still do not know the underlying mechanisms for the euro’s effect on financial integration. For example, is the documented positive effect of the euro on financial integration driven by the elimination of the currency risk among member countries? Or is it also the outcome of the various financial sector legislative-regulatory reforms that the EU countries undertook simultaneously with the euro's introduction? What if the positive effect of the euro on financial integration is simply due to increased goods trade? Dissecting aggregate correlations is vital for policy making, as we still need to understand which policies contribute to the development of an integrated, efficient, and competitive European financial market.4

Recent evidence

In our recent work, we address these questions exploiting a unique confidential dataset from the Bank of International Settlements that reports bilateral (country-pair) cross-border bank assets and liabilities for twenty advanced economies over the past thirty years. We start our empirical analysis quantifying the aggregate effect of the euro on cross-border financial integration employing difference-in-differences specifications that compare the "within" country-pair impact of the single currency among the twelve initial euro area member countries (the "treatment" group) with the general evolution of banking activities across the "control" group of economies, which consists of other advanced EU and non-EU countries.

Our results suggest that bilateral bank holdings and transactions among the euro area economies increased by roughly 40% following the adoption of the euro. When we restrict our analysis to the more homogeneous EU15 sample, we find that financial integration has increased by around 25%-30% among the initial twelve euro area nations as compared to the increase in banking integration in the three EU15 nations that decided not to join the single currency (i.e. the UK, Sweden, and Denmark). These estimates, though highly significant, are much lower than the ones found in previous studies examining the impact of the single currency on various types of capital flows/holdings. Yet, these results seem more plausible as we now quantify the average increase in financial integration after 1999 within pairs of countries that have adopted the single currency.

We then examine the impact of three underlying sources for the euro’s significant aggregate effect for financial integration. First, using recently compiled data on the nature of the exchange rate regime (from Reinhart and Rogoff 2004 and Ilzetzki, Reinhart, and Rogoff 2008), we explore the impact of eliminating currency risk among the euro area countries. Our results show that cross-border banking integration increases significantly after countries adopt hard pegs. Thus, the minimisation of the exchange rate risk is a key mechanism explaining the growth of cross-border financial linkages among the euro area countries after 1999, but it also explains pre-euro growth when European countries adopted strict pegs by joining the exchange rate mechanism.

Second, we examine the impact of legislative and regulatory harmonisation policies in financial services that European countries implemented alongside monetary union. To do so, we construct a new dataset that records the timing of the transposition of each Directive of the Financial Services Action Plan (FSAP) across EU countries. The FSAP was launched in 1998 and included 42 measures aimed at creating a harmonised EU market for banking, securities, and insurance. The most important part of the project consisted of 27 EU-level Directives and 2 Regulations. While Regulations become enforceable immediately across the EU, the Directives are legislative acts that require from member states to achieve some well-specified results without clearly dictating the means. Most importantly, EU countries have some discretion in the timing of the adoption (transposition) of the Directives into the domestic legal order. European governments usually delay the transposition of the Directives to national law for various reasons such as shielding local firms from competition and protecting domestic interests.

Hence, the transposition of the Directives takes several years and differs considerably across the continent. As a result, we have significant country and time variation in the adoption time of the 27 legislative acts. Our estimates indicate that cross-border banking activities increased significantly among European countries that quickly adopted the financial services Directives of the FSAP. Although financial services legislative harmonisation is a significant driver of banking integration, it does not wholly explain the euro’s effect.
Third, we investigate whether cross-border banking integration is driven by an increased volume of transactions in international trade. As goods and asset trade move in tandem and currency unions raise bilateral trade, the positive impact of the single currency on financial integration may be (partly) due to increased goods trade. Although there is a strong correlation between banking activities and international trade even when one accounts for country pair fixed-factors and time trends, goods trade cannot explain the increased bilateral financial linkages.

Policy implications

European policy makers hoped that by promoting financial (and trade) integration, the single currency could spur welfare by speeding productivity growth, lowering consumption volatility, and enabling risk-sharing.5 On the other hand, cross-border financial linkages have been at the core of the transmission of the ongoing crisis that has quickly spread from the US to other economies. Understanding the impact of the single European currency on financial integration and the underlying mechanisms is therefore crucial for designing the new rules of the game for global financial markets.

Our analysis suggests that the euro has been a major force in driving financial integration mainly because foreign investors have a strong preference for currency stability. We also find that legal-regulatory harmonisation policies in financial services have contributed crucially to the deepening of European financial markets. This result not only offers support to European policy makers who are currently considering further harmonisation of the regulation of capital markets and banks across Europe, but it also implies that the currently discussed measures at the G7, G20 and the Financial Stability Forum to harmonise financial regulation may further speed financial globalisation.


Baldwin, R. A. (2006) "The Euro's Trade Effects", ECB Working Paper Series No. 594.
Guiso, L., Sapienza, P. and Zingales, L. (2009), "Cultural Biases in Economic Exchange?" Quarterly Journal of Economics, forthcoming.
Ekinki, M. F., Kalemli-Ozcan, and Sorensen, B. (2007) “Capital Flows within EU Countries: The Role of Institutions, Confidence and Trust “ NBER International Seminar on Macroeconomics, 2007

Ilzetzki E., Reinhart, C. M. and Rogoff, K. S. (2008), "Exchange Rate Arrangements Entering the 21st Century: Which Anchor Will Hold?", Mimeo. data available at: http://www.economics.harvard.edu/faculty/rogoff/Recent_Papers_Rogoff

Kalemli-Ozcan, S., Papaioannou, E., and J-L Peydró (2009a). “What Lies Beneath the Euro’s Effect on Financial Integration? Currency Risk, Legal Harmonization, or Trade.” NBER 15034 & CEPR DP 7314.
Kalemli-Ozcan, S., Manganelli, S., Papaioannou, E., and J-L Peydró (2009b). “Financial Integration and Risk Sharing: The Role of Monetary UnionThe Euro at Ten: 5th European Central Banking Conference 13-14 November 2008, Lucrezia Reichlin, Editor.
Lane, P.R. (2006a), "Global Bond Portfolios and EMU", International Journal of Central Banking, 2(1): 1-23.
Lane, P. R. (2006b), "The Real Effects of European Monetary Union," Journal of Economic Perspectives 20, 47-66, Fall.
Lane, P.R. (2008), "EMU and Financial Integration", in The Euro at Ten: 5th European Central Banking Conference, Lucrezia Reichlin, Ed., ECB. IIIS 272.
Mundell, R. (1961), "A Theory of Optimum Currency Areas", American Economic Review, 51(4): 509-517.
Papaioannou, E. and Portes, R. (2008), "Costs and Benefits of Running an International Currency", European Commission, DG-EC/FIN, Special Report on the European Economy, European Economy Economic Papers 348.
Portes, R. and Rey, H. (2005), "The Determinants of Cross-Border Equity Flows", Journal of International Economics, 65(2): 269-296.
Reinhart, C. and Rogoff, K. (2004), "The Modern History of Exchange Rate Arrangements: A Reinterpretation", Quarterly Journal of Economics, 119(1): 1-48.
Rose, A. (2009), "Is EMU Becoming an Optimum Currency Area? The Evidence on Trade and Business Cycle Synchronization," in The Euro at Ten: 5th European Central Banking Conference, Lucrezia Reichlin, Ed., ECB.
Spiegel, M. (2009a), "Monetary and Financial Integration: Evidence from the EMU", Journal of the Japanese and International Economies, forthcoming.
Spiegel, M. (2009b), "Monetary and Financial Integration in the EMU: Push or Pull?," Review of International Economics, forthcoming.

1 See the conference papers of the 5th ECB Central Banking Conference “The Euro at ten: lessons and challenges,”. See Lane (2006b, 2008) and Papaioannou and Portes (2008) for extensive reviews of the literature.
2 See, for example Lane (2006a) on the impact of the euro on bond holdings, and Spiegel (2009a,b) for the effect of the single currency on international banking.
3 The literature on the euro’s effect on trade, while initially produced such large estimates from the cross-sectional approaches, has now converged to much conservative results based on panel data: the euro has spurred trade among the euro area countries by around 8%-20% (see Baldwin 2006 and Rose 2009).
4 See Baldwin (2006) who makes a similar point in the context of the trade literature that assesses the euro’s impact on international goods trade.
5 For evidence on the euro’s impact on risk-sharing, see Kalemli-Ozcan, Manganelli, Papaioannou, and Peydró (2009b).

Topics: EU institutions, International finance
Tags: euro, financial integration

Sebnem Kalemli-Ozcan

Professor of Economics, University of Maryland and CEPR Research Fellow

Elias Papaioannou

Associate Professor of Economics, London Business School and CEPR Research Affiliate

José-Luis Peydró

Associate Professor, Universitat Pompeu Fabra; Affiliate Professor, Barcelona GSE; and Economist, European Central Bank