Financial integration in the euro area: Pro-cyclical effects and economic convergence

This paper investigates the role of financial integration in the macro-economic adjustment process of countries inside EMU. We employ a confidential bilateral version of the locational banking statistics granted to us by the Bank of International Settlements. We use this dataset to measure the impact of the external positions of banks in member countries on firstly, business cycle synchronization, and secondly, long-term economic convergence. To measure the impact on business cycle synchronization, we include intra-European bank capital flows in a New-Keynesian IS equation for the euro area. Second, we use the dataset on bilateral cross-border claims and liabilities to establish a long-term panel cointegration relationship between GDP, housing prices and net bank capital flows. Our results indicate that since the introduction of the euro, financial integration has negatively affected the macroeconomic adjustment process of countries within the union. Cross-border bank portfolios adversely affect business cycle synchronization as well as long-run convergence. •In this research we use a confidential, bilateral dataset from the BIS.•To investigate financial integration and the macro-economic adjustment process of EMU countries•We find that cross-border bank capital flows adversely affect business cycle synchronization.•Both housing prices and net bank capital flows negatively affect economic convergence.•Financial integration can as such thwart the macroeconomic adjustment process of member countries.