Axel A Weber: Discussion of "EMU and Financial Integration" by Philip
Lane and on "Financial Integration and Risk Sharing: The Role of the
Monetary Union" by Sebnem Kalemli-Ozcan et al.
Comments by Professor Axel A Weber, President of the Deutsche Bundesbank, at the Fifth
ECB Central Banking Conference "The Euro at Ten: Lessons and Challenges", Frankfurt am
Main, 13 November 2008.
* * *
1 Introduction
The euro at ten can justifiably be called a success story, and increasing financial integration
in the euro area is a striking example of this. I am therefore pleased to comment on the two
very interesting and insightful papers presented by Philip Lane and by Sebnem
KalemliOzcan, Simone Manganelli, Elias Papaioannou and José Luis Peydró.
Professor Pagano has already given some helpful and meaningful comments on the papers.
In my comments, I shall first concentrate on Philip's reflections on EMU and financial
integration and add to them some findings for Germany. Second, I shall discuss some issues
raised by Sebnem Kalemli-Ozcan et al. in their paper on the role of the monetary union for
financial integration and risk sharing.
2 Philip R. Lane: "EMU and Financial Integration"
Philip Lane : EMU and financial integration

Provides broadly based evidence that the first 10 years of
EMU have seen a remarkable increase in financial integration

Many barriers to full integration still remain, but initiatives
are under way to remove obstacles in the financial
infrastructure

The Eurosystem is supporting these projects (SEPA,
Target 2, T2S)

Challenges a number of general predictions about the
macroeconomic impact of financial integration on the
financial development of euro-area countries, international
risk sharing and net capital movements
13 November 2008 Comments on papers by P. Lane and S. Kalemli-Ozcan et al. 3 o f 10
Philip Lane's paper builds on his extensive research on EMU and financial integration, and
presents us with a comprehensive and well structured overview of recent research and
market developments. The paper provides broadly based evidence that the first ten years of
EMU have seen a remarkable increase in financial integration, even if the extent of
convergence varies across different sectors. Philip notes that there are still many barriers to
full integration, but that initiatives, such as SEPA, Target 2 and T2S should remove some of
these obstacles. This is why the Eurosystem is actively supporting these projects. Philip then
challenges a number of general predictions about the macroeconomic impact of financial
integration on the financial development of euro-area countries, international risk sharing and
net capital movements.
3 Home bias
To complement Philip's findings on financial integration in bond and equity markets, I would
like to focus on one issue of great importance: To what extent has investors' home bias
changed over the past decade? Using German data it can be shown nicely, first, that home
bias has declined and second, that EMU plays a prominent role in how the portfolios of
German investors are diversified internationally.
Home bias: Some findings for Germany

The home bias of German investors has declined

EMU plays a prominent role in how the portfolios of German
investors are diversified internationally. This is due to
decline in transaction costs
-
- harmonisation of financial market institutions (FSAP)
- improved information on foreign investments
13 November 2008 Comments on papers by P. Lane and S. Kalemli-Ozcan et al. 4 of 10
To start with some theory, Solnik's1 (1974) international Capital Asset Pricing Model predicts
- given there are no transaction costs - that the regional diversification of a securities
portfolio should be the same in all countries worldwide and it should copy the structure of the
global portfolio.
In reality, the portfolios in all countries show divergences from this "benchmark portfolio" in
favour of domestic securities; this "home bias" can be explained by transaction costs and
imperfect information, in particular, concerning foreign securities.
In the euro area, transaction costs should have declined significantly with the abolition of
exchange rate movements within the European Monetary Union and further initiatives for
harmonising the financial market institutions by the Financial Services Action Plan (FSAP). At
the same time, information on foreign investments can be expected to have improved within
EMU. To see whether these predictions are true, I shall now investigate the regional
structure of the German international investment position. German investors' preference for
domestic securities is calculated by comparing the share of actual foreign assets held by
German investors with the percentage of foreign assets in the global benchmark portfolio.2
Against this backdrop, home bias on the assets side indicates whether foreign securities are
less intensively (and domestic securities are more strongly) represented in the national
portfolio compared with the benchmark. A home bias would reach the value 100 if investors
were to take exclusively domestic securities into their portfolios. If the benchmark portfolio is
perfectly copied, the home bias would carry the value 0. A negative number of the home bias
indicates that domestic investors invest more heavily in the securities of a particular country
or group of countries than is indicated by the global benchmark portfolio.
Home bias in German equity portfolios
overall home bias home bias vis-à-vis non-EMU countries
100
50
0
-50
euro area bias
-100
-150
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Note: Equity portfolios include investment certificates. The number indicates the underrepresentation of foreign
securities in German portfolios as a percentage of their share in the benchmark portfolio. A negative number
indicates an overrepresentation.
13 November 2008 Comments on papers by P. Lane and S. Kalemli-Ozcan et al. 5 of 10
The calculations yield some interesting results: First, since the start of EMU, the home bias
of German investors in equities has been tending to decline. While, in 1998, German
investors invested 76% of their stock in domestic equities, this share had diminished to 58 %
at the end of 2007. By comparison, the percentage of German equities in the global
benchmark portfolio was 6 % in both years. In our calculations, this yields a decline in the
home bias from 75% to 55% of the benchmark.
Second, German investors have developed a strong liking for stocks of EMU partner
countries - as the corresponding negative home bias demonstrates. In the beginning, the
German "EMU bias" was only small but it has grown to a notable amount during the past
decade. At the end of 2007, the share of EMU equity securities in German investors' portfolio
was 51 % higher than the corresponding portion in the global benchmark portfolio.
Third, with regard to extra-EMU investment, German home bias was also reduced, albeit
slightly.
Home bias in German bond portfolios
overall home bias home bias vis-à-vis non-EMU countries
100
50
0
-50
euro area bias
-100
-150
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Note: Bond portfolios include medium to long-term debt securities. The number indicates the
underrepresentation of foreign securities in German portfolios as a percentage of their share in the benchmark
portfolio. A negative number indicates an overrepresentation.
13 November 2008 Comments on papers by P. Lane and S. Kalemli-Ozcan et al. 6 of 10
These results are not specific to German portfolios. Investors from other EMU countries also
display a bias in favour of German bonds. This is reflected in the disproportionately large
representation of German bonds in the portfolios of the other EMU member states.
To put it in a nutshell, the data on home bias and "EMU bias" with regard to German
crossborder investment in securities give an idea of how EMU has influenced cross-border
financial integration. The home bias is also an important issue when it comes to investigating
international risk sharing. This brings me to the paper by Sebnem Kalemli-Ozcan, Simone
Manganelli, Elias Papaioannou and José Luis Peydró.
4 Sebnem Kalemli-Ozcan et al.: "Financial Integration and Risk Sharing: The
Role of the Monetary Union"
4.1 General remarks
Seblem Kalemli-Ozcan et al.:
Financial integration and risk sharing

Financial integration in EMU has been driven by the
introduction of the single currency and by legislative and
regulary policies striving for harmonisation
⇒The impact of these factors is difficult to disentangle
⇒The authors tackle the banking sector, but other financial
market segments are worth examining as well

Financial integration in the form of cross-border banking
integration increases consumption risk-sharing
⇒May be worthwhile to make a distinction between intra and
extra-euro-area risk sharing
Part I of their interesting and topical paper gives an overview of financial integration in EMU
and describes the main legislative and regulatory policies that EU member states have
implemented in financial markets. Part II provides empirical evidence for the impact of the
single currency and European harmonisation policies on financial integration. Furthermore, it
analyses the implications for consumption risk sharing in the euro area. The main findings
are that the single currency and the harmonisation policies of EU have both fostered financial
integration and that cross-border banking integration increases consumption risk sharing.
4.2 EMU and cross-border banking integration
An important contribution made by Sebnem Kalemli-Ozcan et al. is that they try to
disentangle the impact of the single currency and harmonisation policies on financial
integration. This distinction is of major relevance with respect to the further process of
integration.
The authors' focus on banking integration is appropriate with regard to the subsequent
analysis of consumption risk sharing, where bank lending is deemed to be a prominent
transmission channel. However, it should be kept in mind that there are more financial
market segments of interest and that the euro and harmonisation policies might affect them
to a different degree. As I have already noted, there is strong evidence that monetary union
has fostered integration of markets for equity and long-term debt securities.
4.3 Banking integration and risk sharing
As for the authors' concept of consumption risk sharing, let me make two remarks. First,
consumption smoothing is measured relative to a panel of 20 European and non-European
countries. This reflects the fact that the paper concentrates on differences in consumption
growth across countries and, therefore, analyses international consumption smoothing.
Domestic smoothing is thereby ignored. Furthermore, the estimates do not make a distinction
between whether consumption smoothing of EMU countries takes place within the euro area
or vis-à-vis the rest of the world. It is true that, from a welfare point of view, a distinction
between intra and extra-euro-area risk sharing does not make sense. However, the authors'
conclude that "the increased cross-banking integration due to the euro has improved ex-post
the optimality of the currency union by improving risk sharing". This implies that risk sharing
of euro area countries takes place mainly among each other.
My second comment concerns the way the authors measure consumption smoothing. The
paper regresses international differences in consumption growth on international differences
in GDP growth, multiplied by a term including banking integration. A perfect consumption
smoothing would imply that asymmetric GDP shocks do not transmit into diverging
consumption paths at all.
Following Asdrubali, Sørensen and Yosha (1996) and the modification of Mélitz (2004), it
might be helpful not to stop here but to have a further look at the individual components of
GDP and the respective channels of risk sharing.3
Expressed in logarithms and first differences, GDP growth can be decomposed into4
(growth of private consumption)
Δ =Δ
ln GDP
(consumpti on smoothing)
+Δ CGDP -Δ C
lnln ln
or, in more detail,
Δ =Δ
ln GDP ln C
(growth of private consumption)
+ Δ -Δ
ln GDP ln GNP
(smoothing by net foreign income)
+Δ -Δ
ln GNP ln A
(smoothing by external saving)
+ Δ -Δ
ln A ln C
(smoothing by domestic saving)
Δ -Δ
ln GNP ln A
In this disaggregation, we would expect the term to be the main channel
through which consumption smoothing by cross-border banking integration should work.
βE βH
In the following table, calculated for Germany, the coefficients and indicate the
absorption of additional GDP growth by net foreign income and external saving,
respectively.5 A positive sign stands for a positive effect on consumption smoothing. The
coefficients suggest that international consumption risk sharing in Germany is primarily
achieved by countercyclical net foreign income, whereas external saving tends to go along
with business cycles. This outcome holds for both overall consumption smoothing and
consumption smoothing vis-à-vis other euro-area countries only.
International consumption smoothing
in Germany:
Absorption of additional GDP growth
by net foreign income and external saving
(ßE) (ßH)
Overall vis-à-vis EMU
EWU EWU
βE βH
βE βH
0.01 -0.03 0.13 -0.23
19911998
0.22 -0.17 0.08 -0.16
19992007

International consumption risk sharing in Germany is mainly
achieved by countercyclical net foreign income

External saving tends to be procyclical
13 November 2008 Comments on papers by P. Lane and S. Kalemli-Ozcan et al. 9 of 10
Obviously, your paper goes beyond these simple correlations. It clearly identifies the impact
of cross border banking integration and uses more sophisticated econometric techniques. I
highly appreciate your work and consider it a valuable contribution to the current debate.
Nevertheless, I would like to stress that this interesting topic leaves much room for further
research.
5 Concluding remarks
To conclude, both papers are very instructive in terms of learning more about details of the
ongoing process of financial integration in the European Monetary Union. They have both
shown that cross-border risk-sharing has improved during the past decade and that EMU has
given a major stimulus to this. Our own calculations on the German home bias point in the
same direction. These approaches, therefore, allow us to conclude that EMU has
welfareenhancing effects.
The Eurosystem will do its best to make them come to the fore with full force in the years to
come.