LA SAGA DE LOS RUBIÓ

This section builds upon part of the extensive literature on financial integration and development to better understand the evolution of the European financial system and the implications for its structure. It provides some answers to important questions such as what is a diversified financial ecosystem and what is the role that market mechanisms, with current conditions of financial development, can play in stabilising the financial system and making it more accessible to firms and investors. The first part addresses how risk sharing works and how effective it was in the euro area. It also reviews how capital market integration can improve risk-sharing mechanisms via its risk absorption capacity. The second part provides a comprehensive assessment of legal and economic determinants of financial structure and development, with particular emphasis on the role of market pricing mechanisms. The third part takes a closer look at the long-standing debate on financial development and how it affects economic growth. This sub-section also extends current theories to offer a view on the interaction between financial integration, structure and development and how it channels economic development into economic growth. Finally, the last part of this section provides a summary of macroeconomic and microeconomic rationales for more capital market integration in Europe, while elaborating on previous financial contracting literature to offer a framework to describe the market organisation of the financial system and how (old and new) market pricing mechanisms fit into it.

Introduction

2.1

Financial integration and risk sharing

Financial integration is the process through which different regions or countries become more financially interconnected, ultimately producing private risk sharing. This process involves the free circulation of capital and financial services among those areas. It usually determines an increase in capital flows across these regions and a convergence of prices and returns for financial assets and services.

As discussed in section 1, financial integration in Europe builds upon three principles: a. Right of establishment (a financial institution can set up permanently in any EU

country).

b. Free movement of services (cross-border provision by a firm located in another country through the use of a passport).

c. Free movement of capital (a transfer of assets from one country to an individual or legal entity in another country).

Despite the effort, the financial integration process in Europe is still a work in progress and has recently taken as many steps forward as backward across the different regions. For instance, the introduction of the euro has accelerated the process of integration in those countries adopting the single currency (see Chapter 3 for more details), but the quality of the integration process was questionable (see Box 1). The expected effects of financial integration are certainly greater capital flows across the areas that are financially integrating and a gradual convergence of interest rates as the costs of

Financial integration

arbitrage among those regions go down (the so-called ‘law of the one price’). If there are no frictions, this process of integration would direct capital where it can be best allocated. Financial integration can also create a better environment for more stable direct investments (FDI),26 _{which offer more resistance to capital reversals (sudden stops)}

in the case of shocks (Lipsey, 2001; Albuquerque, 2003) and also some absorption capacity (Sorensen et al., 2007). Overall, financial integration produces ‘collateral benefits’ that improve the financial and economic environment, but the same integration might be difficult to disentangle in the event of collateral damage (Kose et al., 2006). Nonetheless, financial integration can also produce negative side effects. It makes the involved regions more financially interconnected, which can lead to gradual or sudden capital movements of great magnitude. Financial integration can thus more easily spread contagion in case of a financial crisis if it is not well engineered. Policy and regulatory interventions should ensure an effective removal of barriers to the cross-border circulation of capital and services in order to allow the spread of diversified foreign asset holdings across the integrated area.27 _{Private mechanisms of market surveillance and}

information flows are important to dealing with capital imbalances in the financial system. But private agents are not a sufficient for managing risk in financial markets. Depending on the level of financial integration, both markets and financial institutions can be subject to crisis sparked either by self-fulfilling prophecies (Diamond & Dybvig, 1983; Allen & Gale, 1998), which can be triggered by the acceleration of capital movements that a downward business cycle or the failure of a major financial institution or corporation can cause (sunspot events), or by aggregate risk with a deterioration of fundamentals and failures of non-financial firms (Gorton, 1988). For banks, this fragility comes from the intrinsic asset/liability mismatch in the nature of banking activities (Diamond & Rajan, 2001), which create a first-come-first-served rule for bank repurchases of deposits (Gorton, 1988). This means that, even if the bank may undergo a temporary liquidity crisis, the risk that this liquidity issue will affect the solvency of the bank increases self-reinforcing expectations that the bank may be insolvent, thus causing a bank run, i.e. a self-fulfilling prophecy. With some caveats, this also applies to financial markets. In the case of markets, the sector specialisation creates the liquidity mismatch with the immediate liquidation attempt that occurs in a liquidity shock. When expectations about market illiquidity are high, i.e. temporary inability to find a market- clearing price that is in line with the fundamental demand for that financial instrument, the lack of participation will exacerbate illiquidity and drive prices away from fundamentals. Liquidity begets liquidity (Admati & Pfleiderer, 1988; Pagano, 1989; Foucault et al., 2013) in the same way ‘illiquidity begets illiquidity’. Network effects play

Self-fulfilling prophecies & bank runs

26 _{According to the new OECD benchmark definition, foreign direct investment (FDI) “is a category of investment} that reflects the objective of establishing a lasting interest by a resident enterprise in one economy (direct investor) in an enterprise (direct investment enterprise) that is resident in an economy other than that of the direct investor…The direct or indirect ownership of 10% or more of the voting power of an enterprise resident in one economy by an investor resident in another economy is evidence of such a (lasting) relationship.” See OECD FDI Glossary, p. 7, available at www.oecd.org/daf/inv/investmentfordevelopment/2487495.pdf. The use of a 10% threshold is questionable, as in economies with more concentrated ownership this may be too low to

a key role in building up self-fulfilling prophecies. According to the type and intensity of the shock, the run on market liquidity may also take the form of an asset fire sale (Shleifer & Vishny, 1992, 2011; Allen & Gale, 1994).

Ultimately, there might also be direct links between liquidity shocks in the banking system and shocks in financial markets. Traders use capital, and any problem in raising funding can actually exacerbate market illiquidity and vice versa. Market and funding illiquidity can mutually reinforce each other (Brunnermeier & Pedersen, 2008). As a consequence, both markets and intermediaries have to deal with the risk of self-fulfilling prophecies. A fiscal backstop, a lender of last resort and a sound legal system are key safeguards to protect this delicate equilibrium based on trust and thus the system from a ‘bad prophecy’.

To limit negative effects, financial integration can notably produce mechanisms of risk sharing (Obstfeld, 1994; Obstfeld & Rogoff, 1996; Asdrubali et al., 1996; Sorensen & Yosha, 1998), i.e. financial integration is a pre-condition for the development of some risk sharing mechanisms with no reverse causality (Rangvid et al., 2014). Risk sharing improves capital allocation, thus risk is borne by those that can bear it the most and improves asset allocation. In other words, risk sharing reduces the likelihood of a capital reversal during financial crises, as risk is shared across the areas that are financially integrated. The eurozone, for instance, is an example of financial integration with limited risk sharing, which exposed the area to a significant capital reversal from the beginning of the sovereign crisis onwards.

Risk sharing takes place via greater risk diversification, including risk arising from country- specific shocks (Kose et al., 2006; Jappelli & Pagano, 2008). According to Allen & Gale (1995, 1997), risk sharing can take place via cross-sectional and intertemporal risk smoothing.

Risk sharing

Cross-sectional risk sharing occurs mainly through market mechanisms, which allow the distribution of risk among different agents at a specific point in time. This risk sharing mechanism allows an easy liquidation (exit right) but less stability over time, as agents are less resilient to cyclical factors. Cross-border equity ownership (non-controlling holding) is an example of cross-sectional risk sharing. This mechanism works better in case of permanent income or consumption shocks. It also allows more diversification of country-specific shocks or shocks coming from a specific entity or geographical area. Nonetheless, cross-sectional risk sharing may promote specialisation by channelling capital flows towards sectors that have a comparative advantage, ultimately creating exposure to industry-specific shocks (Kose et al., 2004, 2006).

Cross-