Search

After the inception of the euro, the real economy in most member countries remained dependent on credit by domestic banks, which increasingly funded themselves through cross-border interbank funding. We find that this pattern of ‘double-decker’ banking integration exposed domestic banks to sharp declines in cross-border interbank lending during the eurozone crisis. As a result, domestic banks reduced lending, which led to large declines in output in sectors with many small (bank-dependent) firms. We propose a quantitative small open economy model to account for these patterns and conclude that a global banking shock leading to a sudden stop in cross-border interbank lending in the eurozone is required to account for them.

After the inception of the euro, the real economy in most member countries remained dependent on credit by domestic banks, which increasingly funded themselves through cross-border interbank funding. We find that this pattern of ‘double-decker’ banking integration exposed domestic banks to sharp declines in cross-border interbank lending during the eurozone crisis. As a result, domestic banks reduced lending which led to large declines in output in sectors with many small (bank-dependent) firms. We propose a quantitative small open economy model to account for these patterns and conclude that a global banking shock leading to a sudden stop in cross-border interbank lending in the eurozone is required to account for them.

Small businesses (SMEs) depend on banks for credit. We show that the severity of the Eurozone crisis was worse in countries where firms borrowed more from domestic banks (“domestic bank dependence”) than in countries where firms borrowed more from international banks. Eurozone banking integration in the years 2000–2008 mainly involved cross-border lending between banks while foreign banks’ lending to the real sector stayed flat. Hence, SMEs remained dependent on domestic banks and were vulnerable to global banking shocks. We confirm, using a calibrated quantitative model, that domestic bank dependence makes sectors and countries with many SMEs vulnerable to global banking shocks.

EMU was a major step towards deeper financial integration among member states. However, diversification of equity portfolios remained limited while banking integration surged. We argue that the nature of banking integration is of first-order importance for understanding the patterns and channels of risk sharing. While EMU was associated with the creation of an integrated interbank market, as witnessed by an explosion in cross-border interbank flows, “real” banking integration (in terms of cross-border bank-to-real sector flows or banking-consolidation) remained limited. But we find that real banking integration is associated with more risk sharing, while indirect integration via interbank flows is not. Further, indirect banking integration proved to be highly procyclical, which contributed to the freeze in risk sharing after 2008. Based on this evidence, and a stylized DSGE model that allows us to explain these patterns in the data, we discuss implications for banking union. Our results show that real banking integration and capital market union are complements and robust risk sharing in the EMU requires both.