Openness and geographic neutrality: How do they contribute to international banking integration?

Transcription

1 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton Openness and geographc neutralty: How do they contrbute to nternatonal bankng ntegraton? Iván Arrbas 1,2, Francsco Pérez 1,2 and Eml Tortosa-Ausna 2,3 1 UNIVERSITAT DE VALÈNCIA 2 INSTITUTO VALENCIANO DE INVESTIGACIONES ECONÓMICAS 3 UNIVERSITAT JAUME I 1

2 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton Openness and geographc neutralty: How do they contrbute to nternatonal bankng ntegraton? Iván Arrbas 1,2, Francsco Pérez 1,2 and Eml Tortosa-Ausna 2,3 1 UNIVERSITAT DE VALÈNCIA 2 INSTITUTO VALENCIANO DE INVESTIGACIONES ECONÓMICAS 3 UNIVERSITAT JAUME I ABSTRACT The am of ths artcle s to develop new nternatonal fnancal ntegraton ndcators together wth ther determnants: fnancal openness and regularty (balance) of the blateral fnancal flows. The study's contrbuton s based on the defnton of the Standard of Perfect Fnancal Integraton (SPFI). Ths standard characterzes the scenaro attanable when fnancal flows are not geographcally based, and cross-border asset trade s not affected by home bas. We assess the gap between a hypothetcal scenaro of geographc neutralty and the current level of fnancal ntegraton, along wth both of ts components. The emprcal applcaton to the bankng systems of 18 countres accountng for 83% of nternatonal bankng markets over the perod enables us to conclude that the level of fnancal ntegraton has advanced rapdly over the last few years, and s close to 50% as of 2006,.e., we are halfway to the SPFI. However, notable dfferences among countres are both persstent and growng, and the ntegraton level acheved for each bankng system dffers when ether assessed from the fnancal nflows or outflows perspectve. Keywords: Bankng Integraton, Fnancal Globalzaton, Geographc Neutralty, Network Analyss JEL Classfcaton: F15, F21, F36, Z13 RESUMEN El objetvo de este artículo es desarrollar nuevos ndcadores de ntegracón fnancera nternaconal junto con sus determnantes: apertura y regulardad (equlbro) de los flujos fnanceros blaterales. La contrbucón del estudo se basa en la defncón del Standard de Integracón Fnancera Perfecta (SIFP). Este standard caracterza el escenaro alcanzable cuando los flujos fnanceros no están sesgados geográfcamente, y el comerco de actvos fnanceros no se ve nfluencado por el sesgo doméstco. El estudo mde tambén la dstanca entre el escenaro hpotétco de neutraldad geográfca y el nvel de ntegracón fnancera actual, junto con sus dos componentes. La aplcacón empírca se centra en los sstemas bancaros de 18 países, que suponen el 83% de los mercados fnanceros nternaconales, entre 1999 y 2006, y los resultados permten conclur que el nvel de ntegracón fnancera ha avanzado rápdamente durante los últmos años, y está cercano al 50% en 2006, esto es, hemos recorrdo la mtad del camno que nos separa del SIFP. Sn embargo, exsten mportantes dferencas entre países que son persstentes y crecentes, y el nvel de ntegracón 2

3 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton alcanzado para cada sstema bancaro dfere cuando se valora desde la perspectva de las entradas o saldas de captales. Palabras clave: ntegracón bancara, globalzacón fnancera, neutraldad geográfca, análss de redes 3

4 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton 1. Introducton It s generally agreed that nternatonal ntegraton s rapdly advancng n many economc actvtes, n partcular fnance. Captal markets are notable examples of the growng global nterdependency, also evdent n bankng systems. At a regonal level, t s also clear that monetary and fnancal ntegraton acts as a startng pont n the advance of economc and socal ntegraton processes. In the case of Europe, the monetary unon and the plans to encourage the ntegraton of fnancal servces (Fnancal Servces Acton Plan, FSAP) are consdered mportant leverages for constructon of the European Unon fnancal (European Central Bank, 2007). The advantages of an ntegrated fnancal market are assocated wth the hypothess that partcpants follow a sngle set of rules, have dentcal access, and are treated equally (Baele et al., 2004; European Central Bank, 2007; García-Herrero and Wooldrdge, 2007). Expected results of ntegraton would be prce convergence between dfferent geographc markets and ncreasng cross-border allocaton of nvestment. Cross-border ntegraton can proceed gradually, ether globally or regonally, because geographcal proxmty s stll an mportant determnant of trade and fnancal flows (Berger et al., 2000; Portes et al., 2001; Portes and Rey, 2005). However, the development of remote access technologes n fnancal actvtes has taken off and, n cooperaton wth ntegraton polces, makes t possble to bypass the tradtonal requrement of geographcal proxmty between supplers of servces and ther customers. Under these crcumstances, the evaluaton of fnancal and bankng ntegraton has receved a great deal of attenton 1. Most of the results ndcate that the convergence of nterest rates and the ncrease n the proporton of cross-border actvtes confrm the 1 See the revews by Adam et al. (2002), Cabral et al. (2002), Adjouté and Danthne (2003), Lane and Mles- Ferrett (2003), Baele et al. (2004), Dermne (2006), among others. On the premse that ntegraton s advancng, lterature has focused especally on the study of: a) the determnants of the degree of fnancal ntegraton (Vo and Daly, 2007; Papaoannou, 2008); b) the consequences of ntegraton, n partcular on growth (Guso et al., 2004); and c) the relatonshp between fnancal and commercal ntegraton (Avat and Coeurdacer, 2007). 4

5 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton advance of fnancal ntegraton. However, t s necessary to evaluate the ntegraton level acheved, as well as ts trend. Regardng ths, the current scenaro s ambguous, as the results hnge crucally on the ndcators used. The results are often carred out wthout usng precse crtera on the maxmum value attanable by ntegraton, and are therefore unsatsfactory. Wth the am of mprovng the avalable ndcators of fnancal ntegraton, ths study develops three new ndces, focusng on quanttes. Followng a suggeston by Frankel (2000), we shall call the central reference the Standard of Perfect Fnancal Integraton (SPFI). Ths standard corresponds to the state acheved when fnancal crossborder assets and labltes show no geographcal bas, and are not nfluenced by dstance or barrers between countres 2 but only by the sze of the fnancal systems. The SPFI does not have a normatve value. That s, t solely represents a benchmark whch perhaps s currently unavalable that not only requres countres to be more fnancally open, but also to obtan a full and geographcally unbased development of the network of connectons lnkng economes. Thus, the most mportant contrbutons of the study are that, developng the SPFI, we can measure the gap between the current level of nternatonal fnancal ntegraton and the scenaro of complete fnancal globalzaton, so as to evaluate the evoluton of the level of nternatonal fnancal ntegraton, as a startng pont to analyze ther determnants. Prevous ntatves to measure fnancal ntegraton based on prces are preferred by many scholars when consderng an axomatc crteron the complance wth the law of one prce (LOOP) n dfferent geographcal markets. The lterature on fnancal ntegraton based on the LOOP has grown rapdly over the last few years, owng to the exstng data on prces 3. However, the key problem of ths approach s the lack of a benchmark to measure ntegraton n the absence of perfect competton condtons, whch s the most common stuaton n the case of bankng markets. A unque prce would only 2 Frankel (2000) ndcates the need to defne a Standard of Perfect Internatonal Integraton, descrbng the condtons under whch world trade web would operate as a global vllage. 3 See Cabral et al. (2002), Baele et al. (2004), Flood and Rose (2005), Klemeer and Sander (2006), or Vajanne, among others. 5

6 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton exst for homogeneous fnancal products, and not for others that can be dfferentated. In ths sense, convergence of nterest rates s to be expected n markets, such as nterbank and government bonds. However, ths s not the case n retal bankng markets, whch offer dfferentated products for dfferent nvestments and clents, n partcular loans, credts and deposts. In addton, ths lterature consders that the exstence of a unque prce suffces for economc or fnancal ntegraton. However, even f trade, captal and monetary barrers are lfted and prce dfferentals vansh, economc ntegraton may not arse naturally as we must also take nto account other factors such as the ncentves of economc agents to go abroad, the nsttutonal condtons of both the source and destnaton countres especally n terms of property rghts and law enforcement and the nfluence of regulaton, whch s crucal for banks (Pérez et al., 2005). The measures based on volume data are generally consdered less satsfactory. As ndcated by Manna (2004), ths area of research has flourshed comparatvely less than the more establshed lterature on prces/nterest rates (see Dermne, 2002). Nevertheless, when thoroughly examned, quantty-based measures could contrbute sgnfcantly to achevng a precse pcture of ntegraton. Accordng to a recent state-of-the-art survey on economc globalzaton ndcators (OECD, 2005), the current ndcators are nordnately based on the old concept of market openness, whch valuates the weght of external demand (export, mport) n relaton to natonal producton (GDP). The objectve of ths s to understand whether a country and the rest of the world are gven adequate attenton n proporton to the mportance of ther economes. However, ths approach has two mportant shortcomngs. The frst one s that f the GDP s the denomnator of the ndcator for measurng the degree of fnancal openness, ts meanng mght be msleadng because two separate processes are beng convoluted: openness, and ntensfcaton of fnancal actvtes. Bankng openness to the exteror could be measured as the weght of external assets when consderng the balance sheet, AF/A, whle fnancal ntensty measures the proporton between the volume of fnancal actvtes and the real actvty ( A/GDP ). Gven that AF/ GDP = ( AF/ A)( A/ GDP), and that the second term on the r.h.s. has grown remarkably over the last decade n many countres, the GDP-based ndcators of fnancal openness 6

7 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton mght have actually grown strongly even f the weght of the foregn assets dd not ncrease remarkably n the balance sheet ( AF/A ). Therefore, although some avalable measures (see Pérez et al., 2005) consder GDP-based ndcators as vald, we wll not consder them because of the varety of meanngs they may actually convey. A further constrant when measurng the advance of nternatonal ntegraton usng the degree of openness, s that nternatonal ntegraton s not only a queston of ncreasng the openness of countres but also of developng a network of drect and ndrect relatons between economes. From the globalzaton perspectve, the lmtaton of the degree of openness s that t completely dsregards the archtecture of fnancal trade connectons that each country has wth the rest of the world. In our objectve to develop ndexes of fnancal ntegraton whch take nto account ths complexty, two ssues emerge as most relevant n the wde range of lterature, and both are related to the geographc orentaton of flows. Frst, the ratonale for the bases observed n flows, at home or blateral level; second, the analyss of the network of connectons between countres. At the begnnng of the XXI century, several studes consdered that, despte the forces that represent drastc reducton n global barrers to competton n the fnancal servces ndustry (abolton of barrers, deregulaton, mprovements n nformaton processng and telecommuncatons) the fnancal servces ndustry, and retal bankng n partcular, currently reman far from globalzed. The evdence suggests that borders contnue to play an mportant role n the geographc orentaton of fnancal flows, and that home bas s very relevant n the allocaton of resources, as suggested by the equty home bas lterature (see, for nstance Levy and Sarnat, 1970). In partcular, many bankng servces reman local, probably as a consequence of compettve advantages that the superor nformaton of banks about local and non fnancal supplers and customers represents (Berger et al., 2000, 2003; Berger, 2003). As found by Manna (2004), the share of cross-border bankng actvty s remarkably lower for the four largest euro-area countres (Germany, France, Italy and Span) than for the other countres. Ths factor ndcates that geographcal proxmty and common language are stll provdng ratonale for a home bas n bankng retal products, whereas the effect s less pronounced n the wholesale segments, especally nterbank markets. 7

8 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton The lterature on gravty equatons represents the most wdely used emprcal approach to explan the ratonale for geographc bases n trade flows. The gravty equaton relates nternatonal flows to dfferent types of dstance, and to the economc dmenson (GDP's) of the source and destnaton countres. The success of the gravty model explanng data, ncreases nterest by gvng the gravty equaton a structural nterpretaton n dfferent ways. Adoptng the gravty equaton framework to descrbe the nternatonal asset flows s much more recent. The semnal paper by Portes and Rey (2005) merges elements of fnancal lterature on portfolo composton, and nternatonal economcs and asset trade lterature. In ther analyss, cross-border asset flows depend on market sze n both source and destnaton country, as well as on tradng costs, n whch both nformaton and transacton technology play a role. From ths perspectve, dstance may also be mportant n the fnancal cross-border actvtes because t may be regarded as a proxy for nformaton costs, and should enable the modest declne observed n home or regonal bases of flows to be explaned. Thus, the geography of nformaton emerges as a man determnant of the pattern of nternatonal fnancal transactons 4. However, when geographc barrers dsappear because the mportance of fronters dmnshes, and the cost of transport or nformaton falls, the effect of relatve dstance slowdowns and the shares of dfferent countres n the fnancal nflows/outflows of a country ought to be closer to the GDP's shares. In an extreme scenaro of eradcaton of every possblty of remoteness (Scholte, 2002), only the economc dmenson of partners wll matter. The lterature analyzng regonalsm (and ts effects on the ntensty of ntraregonal and extra-regonal trade) also consders the problem of prortzng some connectons over others vs. no-country, or no-regonal, preference stuaton. The concept of geographc neutralty (Summers, 1991; Krugman, 1991, 1996) may be defned as the absence of preferental drectons n flows. That s, the geographc dstrbuton of a country's trade s sad to be neutral f the weght of every partner n the country's trade s 4 Some recent studes have used gravty equatons to descrbe fnancal flows; see, for nstance, Buch and Lpponer (2007), Lane and Mles-Ferrett (2003), Papaoannou (2008), Buch (2005), or Avat and Coeurdacer (2007). 8

9 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton equal to ts weght n the world trade 5. Followng a smlar approxmaton n the fnancal area, Manna (2004) develops eght statstcal ndcators of the ntegraton of the euro area bankng system, two of whch estmate home bas and the dstance of the actual dstrbuton of cross-border postons from the dstrbuton prevalng under the assumpton of nocountry preference. The stuatons of no-geographc preferences n flows wll be an mportant reference to our analyss of the level of fnancal ntegraton. They can be consdered equvalent to the so-called zero gravty scenaro (see, for nstance Eaton and Kortum, 2002), because dstance does not matter and/or remoteness does not ext. In these scenaros, economes would be perfectly ntegrated through a complex network of connectons, n whch fnancal flows would be the vectors of a graph n whch the nodes represent the countres, so t would be possble to analyze the degree of connectedness n the network. Although these technques are somewhat underused by economsts n comparson wth other socal scences, ths approach s not new n nternatonal economcs 6, and has attracted recent nterest 7. Our analyss of fnancal ntegraton shares two characterstcs wth the network analyss approach. Frst t pays attenton to the number of connectons and the way they are dstrbuted. Second, we judge as mportant not only frst-order relatonshps (drect lnks) but also hgher order relatonshps (ndrect lnks), snce assets mght cross several economes before reachng ther fnal destnaton. Our ntegraton ndex consders these aspects to defne the SPFI, and to measure how far/close fnancal systems, or the global fnancal system as a whole, are to ths scenaro. 5 See also the cted lterature n Gauler et al. (2004), for a dscusson on the measures of regonal trade ntensty and ther lmtatons. 6 Several studes hghlght the mportance of nformaton flowng through cultural, poltcal or economc tes (Rauch, 2001; Rauch and Casella, 2003; Pandey and Whalley, 2004; Combes et al., 2005). For recent bankng applcatons, see McGure and Tarashev (2006), or von Peter (2007). 7 Other studes suggest applyng complex network analyss concepts, topologcal propertes and nstruments from dfferent scences developed to study the structure and dynamcs of nternatonal trade, usng nstruments such as centralty, network densty, clusterng, assortatve mxng or maxmum flow. See, for nstance Kal and Reyes (2005). 9

10 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton On the bass of these premses, the rest of the study develops ndcators of fnancal ntegraton whch take nto account the degree of fnancal openness, as well as the regularty of the connectons between countres' fnancal systems. The paper s structured as follows. In secton 2, we defne the Standard of Perfect Fnancal Integraton (SPFI), and characterze the ndcators of the degree of fnancal openness, the degree of fnancal regularty, and the degree of fnancal ntegraton for each country and for the global fnancal markets as a whole. In secton 3 we present the data used to apply our methodology to the case of bankng systems, usng avalable data on blateral exchange of assets between a set of 18 countres, whch represents 83% of the world fnancal assets n Sectons 4 and 5 analyze the emprcal evdence obtaned on the ntegraton of the bankng systems, and secton Integraton ndcators: defntons and propertes The ntegraton of nternatonal fnancal markets starts wth the cross-border fnancal flows (foregn assets and labltes). However, ts effects and scope also depend on the structure of current relatons between fnancal markets8. Relevant aspects of ths structure nclude the number of countres each country s n contact wth, and whether the relatonshps are drect or ndrect (.e., whether cross-border fnancal flows cross thrd economes). In addton, the volume of cross-border fnancal actvty between them s also mportant, as well as the proportonalty of ths actvty to the sze of the fnancal markets. If we consder fnancal globalzaton as synonymous of the hghest possble level of fnancal ntegraton, the flow from one country to another would only depend on ther relatve sze because barrers to fnancal trade are lfted and there s no home bas effect. As suggested by the lterature on home equty bas, nvestors should be able to explot the benefts of nternatonal asset dversfcaton, and not concentrate ther nvestments n the assets of ther home country (see, for nstance Strong and Xu, 2003). Consderng ths global scenaro, we wll defne the Standard Perfect Fnancal Integraton (SPFI) as an 8 Although we perform an applcaton to cross-border bankng actvty, we wll refer to fnancal/bankng assets and labltes nterchangeably, n order to ease the readablty and understandng of ths secton. 10

11 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton extenson of the concept of geographc neutralty (Krugman, 1996; Summers, 1991), and as a hypothetcal benchmark that wll not necessarly be reached f dstance and other factors matter. Cross-country fnancal ntegraton does not necessarly mply fnancal globalzaton accordng to the geographc neutralty crteron. A country whose crossborder fnancal flows are lower than those correspondng to the sze of ts total fnancal assets s as far from beng ntegrated as another country whose fnancal flows are above that proporton. Both countres show an unbalanced stuaton, gven that home (nternal) fnancal flows and cross-border fnancal flows are not n accordance wth the geographc neutralty crteron. Therefore, geographc neutralty mples that the proporton of home and foregn assets held by domestc nvestors should be proportonal to the relatve szes of each fnancal system. The absence of geographc neutralty would be equvalent to the equty home bas effect (Lews, 1999), where ndvduals hold too lttle of ther wealth n foregn assets. However, the geographc neutralty concept s far more general, snce devatons from equlbrum are explaned away only by dfferences n the relatve sze of the fnancal systems. Under the neutralty assumpton, a balanced value for the cross-country fnancal actvty exsts, and the followng property must be verfed: Home neutralty (P1): A country whose home fnancal assets are proportonal to ts share of the world fnancal market wll have a hgher level of fnancal ntegraton. Not only the total cross-border fnancal actvty a country has s mportant, but also ts dstrbuton. In a global fnancal vllage, when there are no transacton (nformatonal) costs or regonal preferences, the dstrbuton of the fnancal actvty of a country between the destnaton countres should be characterzed by ther relatve sze. Under geographc neutralty, a country has no preferences of any knd (socal, poltcal, geographcal, etc.) for the drecton of ts fnancal cross-border flows, and they are only determned by the sze of the recpent fnancal systems, as stated by the followng property (P2). Drect nternatonal neutralty (P2): a country that balances ts drect fnancal relatonshps wth other ndvdual countres, n proporton to the sze of ther fnancal systems, wll have a hgher level of fnancal ntegraton. 11

12 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton Fnancal flows between countres reflect only frst-order relatonshps. However, hgher-orders may also be relevant. The set of relatonshps establshed between countres operates lke roads between ctes. Frst, they allow countres to be connected even when there s no drect relatonshp between them. Second, there are dfferent ways n whch flows can reach ther fnal destnaton, dependng on the ntermedatng countres they cross. Goods, servces, and captal may move from one country to another several tmes before arrvng at ts fnal destnaton. Ths possblty enables the nterconnectvty of the world to ncrease, and therefore ts ntegraton. Indrect nternatonal neutralty (P3): a country that renforces ts fnancal lnks wth other countres through balanced ndrect relatonshps whch cross ntermedatng countres wll have a hgher level of fnancal ntegraton. A country can devate from perfect fnancal ntegraton due to some of the factors mentoned above. The mpact of ths devaton on fnancal globalzaton wll depend on the sze of every fnancal system. When a large economy departs from perfect ntegraton, t reduces fnancal globalzaton to a larger extent than a small economy. For example, the nfluence of Germany on fnancal globalzaton s necessarly hgher than, for nstance, the nfluence of Greece. Thus, the ntegraton ndex should also be weghted by the sze of the fnancal systems. Sze (P4): the larger the fnancal market of a country, the more relevant ts ntegraton wll be to the globalzaton of the world fnancal market system (global level of fnancal ntegraton). We say that the world acheves the SPFI f propertes P1 to P4 are verfed at the hghest level, makng ths scenaro an extenson of the concept of geographc neutralty. Gven ts wder coverage, we name t geographc superneutralty. In order to answer the queston of how much countres meet the four propertes above, we must defne an ntegraton ndex and assess the dstance that sets the current level of ntegraton apart from the SPFI. We wll proceed n four stages, each one defnng dfferent ndcators, whch correspond to the next four subsectons. Furthermore, the analyss of the four ndcators s conducted on two levels. The ndvdual level focuses on 12

13 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton each country, and the global level corresponds to the analyss of all economes. On the second level, the weght of each fnancal system enters the aggregaton analyss and allows us to defne our Integraton Index. Let us start wth some defntons. Let N = {1, K, g} be the set of countres and let and j be typcal members of ths set. Let g be the number of countres n N,.e., the number of economes n the analyss. Gven a measurable relatonshp between economes, we defne the flow X as the ntensty of ths relatonshp from economy to economy j. j In each year and for each balance-sheet ndcator, we aval of a g g matrx of data. To keep the presentaton smple we omt the tme ndex, unless ths mght generate confuson. The fnancal market actvty between countres can be evaluated through ether the crosscountry flows of assets or labltes. Moreover, n general the flow wll be asymmetrc, so that X wll not necessarly be equal to X, for all j measures the home assets or labltes for all countres j N j, j N ; and also assume that N. Let X = X be the sze of the fnancal system of country N. We defne j j N as the country 's relatve weght wth respect to the world economy,.e., a = X / X Degree of fnancal openness In the frst stage we characterze the degree of fnancal openness. We start wth the usual defnton but corrected for home bas to take nto account the dfferng szes of the fnancal systems of the countres beng compared. Thus, we are takng nto account that domestc nvestors hold a proporton of home assets, and that ts volume wll vary dependng on the sze of each partcular fnancal system 9. In order to control for home bas, we defne Xˆ as the foregn clams of country (.e., assets held abroad by banks of country, n case we consdered data on bank flows) takng nto account the weght n the X a j 9 As documented by the lterature on home equty bas, the proporton of domestc assets held by domestc nvestors s too bg relatve to the predctons of the standard portfolo theory (see Lews, 1999). We consder that t should be proportonal to the sze of the home fnancal system. 13

14 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton world fnancal system of the country under analyss, namely,. We then defne the relatve flow (cross-border bankng assets or labltes) or degree of fnancal openness between countres and j as DFO j = X / Xˆ. j Xˆ = X Defnton 1 Gven a country N, we defne ts degree of fnancal openness, DFO, as a X DFO j jî N\ å DFOj. (1) ˆ jî N\ X = = å X By defnton the degree of fnancal openness takes the value of 1 f and only f home neutralty s verfed (P1). The degree of fnancal openness yelds nonnegatve results, where a value lower than 1 ndcates that ts cross-border bank flows are lower than the correspondng ones, gven the country's share of the world bankng assets. In the unlkely nstances of values hgher than 1, t would ndcate that country 's cross-border bank flows are hgher than those t should have gven the country's share of the world bankng assets. Dfferences n DFO among countres can be attrbuted to dfferent barrers to fnancal ntegraton (lack of nformaton, regulatons, poltcal or cultural factors, economc rskness, etc.). However, dfferences n the measure of fnancal openness cannot be caused by the bas due to country sze, snce we have corrected for home bas 2.2. Degree of regularty of drect fnancal connectons In ths second stage we analyze whether the connecton of one country wth others s proportonal to the dfferng fnancal systems' szes, or whether ths connecton does not show geographcal neutralty. The latter nstance would contrbute to wden the gap between the current level of fnancal ntegraton and the scenaro correspondng to a We wrte DFO nstead of DFO when general statements on the degree of fnancal openness are beng made, or references to the varable tself, whch do not hang on any specfc country. The same rule wll be appled to the other ndcators. 14

15 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton fnancally globalzed world accordng to the drect nternatonal neutralty property (P2). Thus, we defne the degree of regularty of drect fnancal connectons to measure the dscrepancy between the cross-border fnancal flows n the real world and those correspondng to the SPFI. In the fnancal network, the relatve flow from country to country j n terms of the total fnancal flows of country, α j, s gven by X j α j = (2) X j N \ j where j and α = 0 (recall that X 0 ). Let A ( α ) be the square matrx of relatve flows: the component j of matrx A s α j. = j We consder that the global fnancal system s perfectly connected f the fnancal flows between two countres are proportonal to the relatve sze of ther fnancal systems. A country that s part of a perfectly connected world fnancal system wll hold assets n other countres n proporton to the sze of the destnaton countres. country On the other hand, f the world economy s perfectly connected, then the flow from to country j should be equal to β Xˆ j, where X j β j = X k (3) k N \ s the relatve weght of country j n a world where country s not consdered. countres Note that j N \ j β = 1 and that β j s the degree of fnancal openness between and j n the perfectly connected world, wth β = 0. Let B ( β ) be the square matrx of degrees of openness n the perfectly balanced connected world. = j 15

16 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton Startng from the prevously defned matrces, we can defne an ndcator that measures the dstance between the real dstrbuton of fnancal flows and that correspondng to a perfectly balanced connected world. We consder the cosne of the angle of the vector of relatve flows wth the vector of the flows n a perfectly connected world. Defnton 2 Gven an economy fnancal connectons of,, as DRDFC N we defne the degree of regularty of drect DRDFC α jβj j N ( ) ( ). 2 αj βj = 2 j N j N (4) Although the cosne of two vectors ranges between 1 and 1, the degree of drect fnancal connectons always takes nonnegatve values gven that both vectors have only nonnegatve components. DRDFC measures whether fnancal systems meet P2, provdng a sngle value that equals 1 f and only f a country meets the property of drect nternatonal neutralty, and approaches zero for a country whose cross-border fnancal flows are drected towards the smallest fnancal systems Degree of regularty of total fnancal connectons In the thrd stage, we consder the ndrect relatonshps between countres along wth ther mportance. In order to extend the analyss of fnancal market ntegraton n ths drecton, we defne the degree of regularty of total fnancal connectons, whch evaluates the mportance of all drect and ndrect relatonshps that countres establsh wth each other. Both the real world matrx A and the perfectly connected world matrx consder drect relatve flows between countres. However, part of the flow from country to country j may cross thrd countres, and those ndrect flows also contrbute to ntegraton. B 16

17 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton n n n Let A = A A K A be the n -tmes product matrx of matrx A and let be the n n element j of A. It s not dffcult to show that α s the relatve flow that goes from to j crossng n 1 ntermedate countres. Moreover, t s verfed that 0 n 1 for all n 1. In the same way we defne through all countres n a perfectly connected world. j n B, the elements of whch evaluate the flow passng Let γ (0,1) be the proporton of flow that country receves from another country and remans nvested n the frst one, whle α j α j 1 γ s the proporton of receved flow that a country redrects to another country. For estmatng γ, an addtonal assumpton s needed. Let us assume that ths proporton s equal to the proporton of fnancal flows of country that reman as home fnancal nvestment. If country verfes ths assumpton, then the followng equalty holds, X = (1 γ ) L + (1 γ ) L = (1 γ ) L F H F X F H where s the country assets ssued from other countres and are the home L labltes. Gven that L = X j N \ t mples that 1 γ = X / X or equvalently j γ X / X. (5) = Therefore, under our assumpton γ s the proporton of fnancal flows that are nternally nvested n country. Of course, the procedure to estmate γ wll hnge on the flow consdered ether nflow or outflow. Let Γ be the square dagonal matrx of drect flow proportons, so that the element of Γ s γ and the element j, for j, s zero. The matrx of total flows from one country to another s the sum of the drect and ndrect flows and can be estmated as A G 1 = ( I ) n - G - G A n å n=1, (6) 17

18 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton B G å - 1 = G( I- G) n B n n=1 (7) where I s the dentty matrx of order g. Both expressons depend on matrx Γ. Γ Γ Γ Let α be the element j of the matrx A and be the element j of the matrx j Γ B. Each element of these matrces s the weghted sum of the drect and ndrect flows through any possble number of ntermedate economes. We can verfy that the above two seres are convergent. β j 18

19 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton Defnton 3 Gven an economy connectons of, DRTFC Γ, as N we defne the degree of regularty of total fnancal DRTFC Γ Γ Γ α j βj j N ( ) ( ). Γ 2 Γ αj βj = 2 j N j N (8) The degree of fnancal regularty of total connectons ranges n the nterval. It measures the dstance of the drect and ndrect fnancal flows of a country from what ts fnancal flows would be n a perfectly connected world fnancal system. Smlarly to the degree of fnancal regularty of drect connectons, t should equal 1 when the fnancal flows of a country are proportonal to the sze of the recpent countres (ndrect nternatonal neutralty). It should be close to zero f the largest countres do not receve any fnancal nflows and the smallest receve all of them. (0,1) We should bear n mnd that f there are no ndrect flows,.e., γ = 1 for all countres, then expressons (6) and (7) yeld Γ A = A and Γ B = B. Thus, the degrees of regularty of total connectons and regularty of drect connectons concde. The lmt case γ = 0 (fnancal products and servces go through an nfnte number of transformatons before reachng ther fnal destnatons) cannot be derved drectly from the above expressons. The basc lmt theorem of Markov chans 11 s needed to show that when γ = 0 the proporton of flow a country j receves from a country s ndependent of,.e., all countres send the same proporton of flow to economy j Degree of fnancal ntegraton 11 By defnton we verfy that α β = 1 j N j = j N j, thus both matrces A and chans and t can be proved that they are recurrent rreducble aperodc Markov chans. B defne Markov 19

20 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton From the concepts above we defne the degree of fnancal ntegraton, whch combnes degrees of fnancal openness and fnancal regularty of total connecton, provded that both set lmts to the fnancal ntegraton level acheved. 20

21 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton Defnton 4 Gven an economy as Γ N we defne ts degree of fnancal ntegraton, DFI, DFI = mn{1/ DFO, DFO } DRTFC (9) Γ Γ The degree of fnancal ntegraton of a gven country s the geometrc average of ts devaton from the balanced degree of fnancal openness and fnancal regularty of total connectons. Therefore, DFI depends on both the openness of the bankng system and the balance n ts drect and ndrect flows wth other fnancal systems. Moreover, f and only f the fnancal system verfes propertes P1 to P4, then DFI wll be equal 1. If DFI = mn{ DFO,1/ DFO } DRTFC, then Γ Γ mn{ DFO,1/ DFO } DRTFC Γ 1 = (10) Γ Γ DFI DFI and we can nterpret each of these two factors as the weght that the degrees of openness and regularty of total connectons have over the degree of ntegraton. In a gven economy, ths can be useful to analyze changes over tme n the weght of the factors Other global ndcators In the prevous subsectons we have defned several ndcators that characterze the ntegraton of each ndvdual country and that, as the degree of fnancal ntegraton, can also be summarzed for the whole economy: Degree of global fnancal openness: DGFO a DFO. = N (11) Degree of regularty of global drect fnancal connectons: DRGDFC a DRDFC. = N (12) 21

22 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton Degree of regularty of global total fnancal connectons: Γ Γ DRGTFC = a DRTFC. (13) N To characterze the ntegraton of the whole economy, we should consder the share of each economy n the world (property 4) to defne the global ndcator as follows (recall j N that a = X / X ), j Defnton 5 We defne the degree of fnancal ntegraton (globalzaton) of the whole economy as The DGFI Γ Γ DGFI = a DFI. (14) N ndcator s the most general quanttatve approxmaton to the nternatonal fnancal market ntegraton of countres, as t consders not only the degree of fnancal openness, but also the dstrbuton of the drect and ndrect flows between countres, and the sze of a country's fnancal system. In lght of the dfferent concepts ncluded n ths defnton, the ndcator wll be consdered as a Globalzaton Index for the world fnancal system, accordng to propertes P1 to P4. The frst three propertes are an ncreasng functon of DGFI for any country. Property P4 s verfed because DGFI s a weghted average of the countres' degree of ntegraton, where the weght of each country depends drectly on ts sze. The degree of fnancal ntegraton measures how close the world s to the SPFI, whch should be equal to 1 when all countres are perfectly ntegrated and acheve ther theoretcal potental of ntegraton n a world wthout any remoteness. 3. Data Our data set contans nformaton on both total assets of the dfferent bankng ndustres under analyss, and bank foregn clams for both fnancal outflows and nflows. That s, assets held abroad by banks of a gven country (outflows), and bank assets of a gven country owned by foregn banks (nflows). The data on blateral bankng fnancal 22

23 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton assets are provded by the Bank of Internatonal Settlements (BIS) 12, whch ssues quarterly the nternatonal clams of ts reportng banks on ndvdual countres, geographcally broken down by natonalty of the reportng banks. Our data contans nformaton on the largest world economes, and also on some specfc countres wth large bankng systems such as Swtzerland, to the total of 18 countres. The data on total assets are provded by the European Central Bank for European Unon countres, and by the central bank of each country, wth some exceptons. Our data set s also crucally determned by the avalable nformaton, whch was ncomplete n terms of countres and sample years. Fnally, only eghteen countres and eght years ( ) were selected to perform the analyss. Stretchng the sample perod n both dmensons,.e., countres selected and length of the perod, led nevtably to ncomplete data sets and dffcultes for drawng conclusons on the dynamcs of fnancal globalzaton. Furthermore, even f some addtonal countres for whch nformaton was avalable for some years were ncluded n the sample 13, the gans n terms of total bank assets were not substantal, as the constraned sample accounted for more than 90% of the enlarged sample. Our data also refers to flows from consoldated banks, consttutng a clear advantage to avod double countng compared to usng unconsoldated balance sheet data, whch s the usual approach followed by many other studes on bankng ntegraton. Table 1 provdes nformaton on these matters. As shown by columns fve and sx, t s qute apparent that the U.S. fnancal system s far less bancarzed than large European countres such as Germany, Italy, France, or Span. As of 2006, the share of the U.S. bankng system was qute small (14.84%), especally takng nto account the sze of the U.S. economy. As also ndcated n table 1, the total assets of the U.S. bankng system n terms of GDP are well below those of the other countres n the sample. 12 See 13 Australa, Brazl, Canada, Chle, Mexco, Panama and Tawan. 23

24 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton Cross-border clams have also been ncreasng sharply for all countres and, as documented by some authors, today they are over 30 tmes larger n absolute terms than thrty years ago (McGure and Tarashev, 2006). Ths nformaton s reported n columns seven through twelve. For all countres there has been a sharp ncrease n foregn clams from 1999 to 2006, not only n absolute terms (columns 11-12) but also as a % or GDP (columns 7-8) or as a % of total assets (columns 9-10). Fnally, columns report 24

25 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton Table 1. Data by country, 1999 and 2006 Country Total bank assets 1 Shares of the nternatonal bankng markets Total assets as % of GDP Total consoldated foregn clams as % of GDP Total consoldated foregn clams as % of total assets Total consoldated foregn clams 1 Total consoldated foregn clams of the sample countres as % of ther total foregn clams Total consoldated foregn clams of the sample countres as % of total assets Austra 488,939 1,040, , , Belgum 718,791 1,480, , , Canada 1,120,339 2,285, , , Denmark 356, , , , Fnland 120, , ,845 71, France 3,643,785 8,126, ,008 2,145, Germany 5,704,621 9,422, ,333,868 2,816, Greece 181, , NA NA NA 16,996 NA NA 4.02 Ireland 304,193 1,915, , , Italy 1,649,453 3,780, , , Japan 7,517,125 6,300, ,596 1,339, Netherlands 988,225 2,466, ,146 1,872, Portugal 250, , ,082 89, Span 1,048,501 3,313, , , Sweden 477,890 1,103, , , Swtzerland 1,402,756 2,617, ,789 2,114, Unted Kngdom 3,802,069 9,992, ,207 2,253, Unted States 5,596,500 9,750, , , In mllons current US$. 25

26 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton nformaton on the representatveness of our sample, whch vares dependng on the country but s generally qute hgh. The analyss performed n the ensung sectons wll focus on both drectons of foregn clams. That s, not only on bank assets held abroad by banks of a gven country (cross-border bank outflows) but also on bank assets of each country owned by foregn banks (cross-border bank nflows). We wll refer to each drecton usng the out and n superscrpts, n order to refer to outflows and nflows, respectvely. Table 1 contans nformaton on outflows only, so as to save space and also because the nformaton on total consoldated foregn clams of the sample countres ether as a percentage of ther total foregn clams or ther total assets (.e., the nformaton reported by columns 13-16) s not avalable for nflows. 4. Emprcal evdence: the ntegraton of the nternatonal bankng systems 4.1. Degree of fnancal openness Table 2 shows the results of the degree of fnancal openness for years 1999 and 2006.e., the ntal and fnal sample years. The frst two columns refer to assets held abroad by banks of each country lsted, whereas columns three and four refer to bank assets of a gven country owned by foregn banks. Results vary a great deal n several dmensons. Lookng at country dfferences, we notce that the most open fnancal systems n terms of assets held abroad as of 2006 are those of Swtzerland, the Netherlands, and Belgum, ndcatng that the assets held abroad by banks from these countres represent the 85.2%, 75.8%, and 66.0% of ther total assets. These are mportant nternatonal fnancal centers, and therefore have large external portfolos (Lane and Mles-Ferrett, 2008). Although these are small countres, we must take nto account that when dvdng by total assets we control for home bas. That s, the fact that the share of cross-border actvty s markedly lower for the largest country (Manna, 2004), and therefore countres wth the largest bankng markets could have also hgh degrees of fnancal openness. In contrast, the Greek, Italan and U.S. bankng markets are far less nternatonalzed, as shown by degrees of 26

27 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton fnancal openness of 4.0%, 8.0%, and 10.5% by Even f we control for home bas, the assets held abroad by banks n these countres are extremely low. Table 2. Degree of fnancal openness ( DFO ) (%) out DFO n DFO Country Austra Belgum Canada Denmark Fnland France Germany Greece NA Ireland Italy Japan Netherlands Portugal Span Sweden Swtzerland Unted Kngdom Unted States Unweghted mean Standard devaton Coeffcent of varaton These results vary, not only across countres but also over tme. Indeed, many countres show cross-border bank flows whch have ncreased sharply. In some cases such as Denmark, the Netherlands, or Sweden they have more than doubled, whle n others they have also been substantal but more moderate. Of specal note s the case of some large 27

28 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton European countres whose degrees of openness have ncreased a great deal. However, ths s not entrely attrbutable to the effect of the euro, snce some of the largest ncreases have taken place n countres whch have not yet adopted the sngle currency (bascally Denmark and the U.K.). These patterns vary when consderng the nternatonal bank flows n the opposte drecton,.e., the bank assets of each country n the table owned by foregn banks. Results dffer greatly, especally for the most extreme cases. Indeed, the correlaton coeffcent s 38.2% countres whose for year 2006, and ths hghly negatve sgn holds for all sample years. Some out DFO was qute hgh, such as Swtzerland, have now become much more closed. On the other hand, the U.S. s qute open n terms of bank assets n the U.S. held by foregn banks. Dsparty n the results s the general tendency. Apart from the U.S. some countres have now become much more open such as Fnland, Greece, Italy, Portugal, or the U.K. In contrast, others become less fnancally open Belgum, Canada, France, Germany, Japan, the Netherlands, Sweden, and Swtzerland. These tendences are summarzed n fgure 1, whch contans nformaton on dfferent aspects of the dstrbuton of the degrees of fnancal openness. The upper panels show the evoluton of relevant summary statstcs such as the mean both weghted and out n unweghted. Both statstcs show a tght upward trend, for both DFO and DFO, whch has ncreased by roughly 50%. It s also worth notng the smlartes between the patterns found for both weghtng schemes, suggestng that the enhanced nternatonalzaton has occurred regardless of the sze of the bankng markets n each country. The lower panels n fgure 1 provde nformaton on the entre dstrbutons of the varable under analyss va voln plots 14. Accordngly, each fgure contans both the box plot and the densty trace, whch s plotted symmetrcally to the left and rght of the vertcal box plot. In our case, we provde nformaton for both ntal and fnal years, and both 14 As ndcated by Hntze and Nelson (1998), voln plots combne the box plot and the densty trace nto a sngle dsplay that reveals structure found wthn the data. Therefore, t contans both the nformaton provded by box plots (such as center, spread, asymmetry, and outlers), but also the dstrbutonal characterstcs of data contaned n nonparametrc densty estmaton (Slverman, 1986). 28

29 Prelmnar verson to be publshed as Workng Paper by BBVA Foundaton out n DFO and DFO. Both cases show a tendency n the dstrbuton to become more spread, although asymmetrcally. That s, some (very few) countres are becomng more open n both drectons, but most of them reman n the lower tals of the dstrbuton. However, voln plots do not offer nformaton on the relatve postons, or ntradstrbuton moblty over tme. We do not know unless we examne data ndvdually whether some countres are movng upwards n ther fnancal openness rankngs over tme, leavng us wth an apparently stable dstrbuton. 29