DP7292 Financial Integration and Business Cycle Synchronization

Author(s): Sebnem Kalemli-Ozcan, Elias Papaioannou, José Luis Peydró
Publication Date: May 2009
Keyword(s): Banks, Business Cycles, Co-movement, Financial Integration, Financial Regulation
JEL(s): E32, F15, F36, G21, O16
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7292

Standard theory predicts that financial integration leads to a lower degree of business cycle synchronization. Surprisingly, cross-country studies find the opposite. Our contribution is to document the theoretically predicted negative effect of financial integration on business cycle synchronization as a robust regularity. We use a confidential dataset on banks' international bilateral exposure over the past three decades in a panel of twenty developed countries. The rich panel structure allows us to control for time-invariant country-pair factors and global trends that affect both financial integration and business cycle patterns. In contrast to previous empirical work we find that a higher degree of financial integration is associated with less synchronized output cycles. We also employ two distinct instrumental variable approaches to identify the one-way effect of integration on synchronization. These specifications reveal that the component of banking integration predicted by legislative-regulatory harmonization policies and the nature of the bilateral exchange rate regime has a negative effect on output synchronization.