Banking union in a single currency area: evidence on financial fragmentation

Abstract

Purpose

The purpose of this paper is to assess the impact of the impact of the single currency on the institutional design of the banking union, through evidence on the financial integration process.

Design/methodology/approach

Data analysis uses multiple sources of data on key drivers of financial fragmentation. The paper starts from a snapshot the status of financial integration and then identifies the main components of this trend.

Findings

Evidence shows that financial integration in the euro area between 2010 and 2014 retrenched at a quicker pace than outside the monetary union. Home bias persisted. Under market pressures, governments compete on funding costs by supporting “their” banks with massive state aids, which distorts the playing field and feed the risk-aversion loop. This situation intensifies frictions in credit markets, thus hampering the transmission of monetary policies and, potentially, economic growth. Taking stock of developments in the euro area, this paper discusses the theoretical framework of a banking union in a single currency area with decentralised fiscal policy sovereignty. It concludes that, when a crisis looms over, a common fiscal backstop can reduce pressures of financial fragmentation, driven by governments’ moral hazard and banks’ home bias.

Research limitations/implications

Additional research is required to deepen the empirical analysis, with econometric modelling, on the links between governments’ implicit guarantees and banks’ home bias. This is an initial data analysis.

Originality/value

Under market pressure, governments in a single currency area tend to be overprotective (more than countries with full monetary sovereignty) towards their own banking system and so trigger financial fragmentation (enhancing banks’ home bias). To revert that, a common fiscal backstop is an essential element of the institutional design. The paper shows empirical evidence and theory, as well as it identifies underlying market failures. It links the single currency to the institutional design of a banking union. This important dimension is brought into a coherent framework.

Citation

Valiante, D. (2015), "Banking union in a single currency area: evidence on financial fragmentation", Journal of Financial Economic Policy, Vol. 7 No. 3, pp. 251-274. https://doi.org/10.1108/JFEP-10-2014-0058