Given all of the hubbub regarding the PIIGS countries and the Eurozone, I thought it would be a good time to review a paper I had read a few months back, entitled What Lies Beneath The Euro’s Effect on Financial Integration:  Currency Risk, Legal Harmonization, or Trade? by Sebnem Kalemli-Ozcan, Elias Papaioannou, and Jose-Luis Peydro.

Abstract:

Although recent research shows that the euro has spurred cross-border financial integration, the exact mechanisms remain unknown. We investigate the underlying channels of the euro’s effect on financial integration using data on bilateral banking linkages among twenty industrial countries in the past thirty years. We also construct a dataset that records the timing of legislative-regulatory harmonization policies in financial services across the European Union. We find that the euro’s impact on financial integration is primarily driven by eliminating the currency risk. Legislative-regulatory convergence has also contributed to the spur of cross-border financial transactions. Trade in goods, while highly correlated with bilateral financial activities, does not play a key role in explaining the euro’s positive effect on financial integration.

The data set they use is a confidential set held by the Bank of International Settlements.  With it, they note that “bilateral bank holdings and transactions increased by roughly 40% among the euro area countries” (2).  The normal explanation of this is the reduction of currency risk and elimination of exchange rate fluctuations between countries, and the authors test this.  They find that “once we control for the nature of the exchange rate regime […] the euro’s positive effect is maily driven by elimination of the currency risk” (3).

But there is another theory:  that countries which join the Eurozone must adopt EU regulations and a common set of legal, regulatory, and supervisory legislation.  The theory here is that countries are not competing on these grounds, there will be more cross-border interaction, as political borders will be much less significant an issue with the rules all being the same.  The result here was much smaller, although the authors argue that their measurements likely under-estimated the true values (13-14).

In their conclusion, the authors write that one of the areas for future research is how risk-taking by banks has been affected by the development of the Euro.  Given what we have learned over the last few months, I would venture to say that risk-taking by governments as a result of the development of the Euro is the more fruitful topic.

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