Project Summary

This research project aims at developing a solid understanding of the channels through which shocks are transmitted through and between various financial market segments in Europe. In particular, we will study the role played by the banking industry, the bond market, and the equity market for the transmission of shocks.

The banking sector continues being the main source of financing in Europe, and hence, constitutes an important channel through which shocks are transmitted through the European economy. Over the last two decades, the banking industry has gone through a period of considerable deregulation and integration. In this project, we will measure to what extent further integration has changed the risk structure of the European banking industry. At the same time, we will investigate the relationship between bank risk and certain strategic choices banks have made, e.g. regarding their degree of functional diversification or their capital buffer. This should yield interesting information for policy makers and bank regulators trying to limit the systematic risk of the banking sector. One consequence of further credit market integration is that banks have increasingly engaged in cross-border activities. In a separate paper, we explicitly investigate to what extent international activities of banks transmit shocks across borders.

As regards Europe’s equity markets, in a first project, we will investigate to what extent further economic, monetary, and financial integration has increased the intensity by which shocks are transmitted between European equity markets. One channel through which equity markets may become more interrelated is through a convergence in the cost of equity capital. As a consequence, in a second project, we will quantify the impact of further integration and increasing possibilities of international risk sharing on the cost of equity capital of European countries and industries. While further financial integration has large potential benefits, an often-heard critique is that it also makes equity markets more vulnerable to contagion effects. Consequently, we will also investigate to what extent European equity markets are now more vulnerable to contagion. As evidenced by the recent turmoil in Asian financial markets, developing a better understanding of the causes and consequences of contagion effects is of utmost societal importance. Notice, however, that equity market integration may not only have a real impact on the economy through a reduction in the cost of capital, but also through wealth effects. More specifically, increased equity market participation, either directly or indirectly through mutual or pension funds, is likely to have made consumption more sensitive to the performance of the aggregate equity market. This channel is explicitly investigates in a third project. Finally, the project looks more closely at the equity markets for fast-growing firms. These markets play an important role in making the European economy more dynamic and market-based.

A striking feature of euro area government bond markets is that nominal yields have converged (nearly) entirely since the introduction of the single currency in 1999. This has considerably reduced the debt servicing cost of many euro area countries. At the same time, however, dispersion in inflation rates continues being substantial. The combination of fully converged nominal rates but diverging inflation results in potentially large differences in real interest rates in the various euro area markets. In this project, we first want to determine the determinants of both real and nominal rates at various maturities. In a second step, we focus on directly on real interest rates. More specifically, we will measure how different real interest rates are in the various euro area countries, and to what extent these differences may potentially acerbate business cycle fluctuations.

Because our research project covers the most important segments of European financial markets, our research will have a significant impact on a broad spectrum of policy issues. These include banking supervision and regulation, the promotion of bond market integration, and the establishment of equity market institutions that help providing firms and investors with a reliable and stable environment for their capital allocation decisions. We also address the appropriate design of monetary frameworks and responses to financial market shocks. In a nutshell, our research project helps European policy makers to assess both the benefits that can be reaped when integrating Europe’s financial markets and the risks on which one should have a keen eye when taking the road to a unified Europe.
Finprop_Presentation.ppt