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The Determinants of Cross-Border Lending in the Euro Zone

The Determinants of Cross-Border Lending in the Euro Zone. The 14th Dubrovnik Economic Conference June 26-27, 2008 Sylvia Heuchemer Cologne University of Applied Sciences Stefanie Kleimeier (not present) Maastricht University and METEOR Fellow

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The Determinants of Cross-Border Lending in the Euro Zone

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  1. The Determinants of Cross-Border Lending in the Euro Zone The 14th Dubrovnik Economic ConferenceJune 26-27, 2008 Sylvia Heuchemer Cologne University of Applied Sciences Stefanie Kleimeier (not present)Maastricht University and METEOR Fellow Harald SanderCologneUniversity of Applied Sciences, and METEOR Fellow

  2. Introduction (1) • European financial market integration has made a big leap forward. • However, retail banking is lagging far behind, though recently gaining some momentum. • We explore the geography of cross-border lending in the euro zone by means of a gravity approach in order to: • identify trade-theoretic determinants of cross-border lending • identify important drivers of and barriers to integration • special focus on exploring the role of cultural and political differences Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  3. Introduction (2) • Gravity models have recently been used in explaining cross-border finance…(e.g. Guiso,Sapienza & Zingales 2005, Blank & Buch 2006) • …and highlighted the limiting role of cultural and political factors in economic exchange(Guiso, Sapienza & Zingales 2005, Heuchemer & Sander 2007, Kalemli-Ozcan & Sørensen 2007) • Our approach innovates on: • using a non publicly available bilateral data on cross-border loans for the euro zone • adapting a trade-theoretically-augmented gravity model to cross-border lending • modeling cultural and political differences in a gravity approach Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  4. Data • Bilateral cross-border loans • Annual outstanding volume from 1999-2006 • Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain • except loans to customers in Lux and Por • More than 800 countrypair-year specific observations Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  5. Data Cross-border loans more than doubled - Increase in banking market integration - Lending is right-skewed, indicating that lending activities are concentrated in a few countries Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  6. Methodology (1) • Gravity models have been successfully applied for explaining transactions over space, mainly trade in goods • The canonical gravity model explains trade flows between two countries as a function of • their respective economic masses (GDP) and • the geographical distance separating them - as a proxy for all information and transaction costs Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  7. Methodology (2) • Augmented gravity models • are micro-founded by adapting them to trade theories(e.g. Anderson 1979, Bergstrand 1985 & 1989 Deardorf, 1989, Anderson & van Wincoop 2003, Baltagi et al. 2003) • Size (sum of GDPs)  “new trade theory” • Similarity (of GDP)  “new trade theory” • Relative per-capita income  Ricardo-HOS-theory vs. Linder • include additional trade impeding or trade promoting factors as proxy for information and transaction cost • distance, common border, language • alternative measures of cultural distances (“Hofstede”, trust to/trust from, differences in trust levels, legal system origin) • Differences in governance quality Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  8. Methodology (3) Augmented gravity model adjusted to banking market analysis: • Size: sum of the GDPs of the trading partner (“new” trade theory) With • Xijt: cross-border loans from bank country to customer country at time t Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  9. Methodology (3) Augmented gravity model adjusted to banking market analysis: • Size: sum of the GDPs of the trading partner (“new” trade theory) With • Xijt: cross-border loans from bank country to customer country at time t • Similar: similarity of the size of the financial sector (“new” trade theory) Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  10. Methodology (3) Augmented gravity model adjusted to banking market analysis: • Size: sum of the GDPs of the trading partner (“new” trade theory) With • Xijt: cross-border loans from bank country to customer country at time t • Similar: similarity of the size of the financial sector (“new” trade theory) • REL: indicator for relative financial development (“old” or “new” trade theory) Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  11. Methodology (3) • Distance: geographical distance between two countries • Border: dummy variable that is 1 if two countries share a common border and 0 otherwise • Yijt: additional factors possibly influencing cross-border lending Augmented gravity model adjusted to banking market analysis: • Size: sum of the GDPs of the trading partner (“new” trade theory) With • Xijt: cross-border loans from bank country to customer country at time t • Similar: similarity of the size of the financial sector (“new” trade theory) • REL: indicator for relative financial development (“old” or “new” trade theory) Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  12. Estimation Procedure • Static Fixed Vs Random Effects Estimation • Static Vs Dynamic Fixed Effects Estimation • habit persistence may be likely in banking (switching and information costs) 3. Least Square Dummy Variables (LSDV) Estimation • Fixed effects estimations eliminate all time-invariant country-pair specific variables we are interested in • LSDV can remedy this, but we have to model the country-pair specific effects Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  13. Estimation Procedure 1: Fixed Vs Random Effects in Loan Markets None of the explanatory variables are statistically significant. Variation in cross-border loans can be explained by country-pair and time specific factors. 0,983 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  14. Estimation Procedure 1: Fixed Vs Random Effects Estimation • Hausman tests substantiate our choice of fixed effects model. • Strong evidence for country-pair fixed effects • Fixed time effects, capturing economic shocks and account for important regulatory and behavioral changes in the first years of the currency union Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  15. Estimation Procedure 2: Dynamic Fixed Effects • Habit persistence is likely in retail banking (information and transaction costs) • Arellano-Bond Estimator Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  16. Data and Estimation Procedure 0,30 0,70 Model performs better without time dummies capturing regulatory changes. no yes In order to capture regulatory changes Year dummies Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  17. Data and Estimation Procedure 0,62 0,40 Cross-border lending is habit persistent. no yes Year dummies Cross-border lending is promoted by similarity of financial systems. 0,52 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  18. Estimation Procedure 3: LSDV • Summary of the Fixed Effects Models • Strong evidence for country-pair FE • Habit persistence in loan markets • Least Square Dummy Variables (LSDV) Estimation • Fixed effects estimations eliminate all time-invariant country-pair specific variables which we are interested in • LSDV can remedy this, but we have to model the country-pair specific effects Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  19. Estimation Procedure 3: LSDV with V as possible influencing factors on cross-border lending • Country-pair fixed effects are replaced by country-pair specific economic, cultural and political variables measured as Euclidean distance or as dummy variables • Country specific effects (country dummies) are included, capturing the effects of “multilateral resistance” • Time dummies to account (at least partly) for habit persistence Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  20. Data (extended): Cultural and Political Proxies • Cultural proxies • Common language • Legal family (La Porta et. al) • Trust_from/Trust_to (Eurobarometer and Guiso et. al) • Trust levels (World Value Survey) • Overall cultural proxy based on Hofstede’s cultural dimensions (power distance, individualism, masculinity and uncertainty avoidance) • Political proxies • Dimension of governance as defined by the World Bank (voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, control of corruption) • Overall political proxy based on all six dimensions Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  21. LSDV Results: LoansBasic Version R2 0,830 Size 1,32 SIM 0,54 REL 0,43 Border 0,54 Dist. -0,59 „New“ Trade Theory „Old“ Trade Theory Economic Geography Intra-industry trade - Product heterogeneity - Economies of scale Comparative Advantages Common borders increase cross-border banking by 71,6% Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  22. LSDV Results: LoansImpact of Cultural and Political Variables Statistically insignificant 0,11 Language -0,01 Corruption 0,03 Gov. Effectivness -0,03 Political Stability -0,06 Reg. Quality 0,00 Rule of Law Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  23. LSDV Results: LoansImpact of Cultural and Political Variables -0,34 Culture -0,24 Trust Statistically significant 0,66 Legal Family 0,11 Foreign Bank 0,09 Voice + Account. Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  24. LSDV Results: LoansPreferred Estimation R2 0,844 Size 0,84 SIM 0,51 REL 0,54 Dist. -0,56 Border 0,48 Trust -0,24 Bank 0,13 Voice 0,14 Legal 0,55 Intra-industry trade Comparative advantages Influence of economic geography is slightly smaller Same legal system increases cross-border loans by 73,3% Cultural (rather than governance) factors play an important limiting role in banking market integration Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  25. Conclusion • Cross-border lending is promoted by similarity of financial systems but… • …differences in factor endowments and financial development still play a role. • Cross-border lending is habit persistent. • Strong geographic and cultural limits to full(er) integration • Distance and border effects • Differences in legal system origin • Cultural Differences (Trust) Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  26. Research Challenges Ahead • Towards a more theory-based measurement of cultural dimensions • Exploring the interaction of the various concepts and proxies for information and transaction costs (also for trade, FDI, international finance) • Efficient estimation of time invariant and rarely changing variables in gravity models with fixed effects (e.g. Hausman/Taylor, or more recently: Plümper/Troeger 2007) Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

  27. Cultural and geographical factors remain for quite some time a barrier to banking market integration in the euro zone. Thank you for your attention! Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander

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