Traditionally there has been a strong focus on the cross-border exposures of individual banks. This is consistent with the micro-prudential approach of Basel, which aims to ensure the solvency of individual banks. Since the Latin American and Asian debt crises in the 1980s and 1990s, authorities have started to measure cross-border exposures at the country level. One might ask, for example, how much French banks are exposed to Asian markets?
We argue that one needs to move further and propose a systemic approach at the regional level. Such an approach is essential to detect (and correct) overexposures at an early stage.
The traditional approach assumes that if most individual banks or countries are solid, so too is the overall system. International finance provides an application of the fallacy of composition (Brunnermeier et al, 2009). It may well be that individual countries in a region are sufficiently balanced, but the region overall has an overexposure to a certain group of countries. A case in point is the overexposure of the European banking system to the US prior to the global financial crisis. This lack of balance provides an explanation for why a crisis that originated in the US spread more readily to Europe than to Asia.
Developing systemic metrics
Financial integration is especially desirable when it makes the most of diversification benefits. Given a certain amount of outward investment from a country, stability benefits are maximised if this investment is appropriately spread among other countries, lowering variance and contagion effects. But how exactly should a country's foreign investment be allocated across the world? Portfolio theory suggests a simple approximation to the allocation problem – that each investor hold a share in the market portfolio (Markowitz, 1952). Portfolio weights for individual assets are thus determined by the share of an asset in the world portfolio, and are independent of the characteristics of the respective investor.
What about the systemic aspect of integration? Even though country and systemic (that is, regional) integration are obviously connected, they do not necessarily coincide. Suppose that each EU country's outward investment exhibits little diversification (in the extreme, it goes to only one other non-EU country). Diversification in individual countries will then be very low. But if these countries specialise their (non-EU) investment in different countries, the EU as a whole may be well diversified. This simple example highlights that it is important to distinguish between these levels of integration.
We argue that cross-border banking in the EU is balanced if the combined banking assets of EU countries are appropriately spread among all other non-EU countries or regions (Schoenmaker and Wagner, 2013). For this we can approximate a region's share in the market portfolio by the assets of its banking sector. The ratio of the EU’s outward investment in another region relative to the EU 's total outward investment should ideally be equal to the share of the other region’s assets in the combined assets of all other non-EU regions. An index of the effectiveness of diversification in outward integration can then be constructed by looking at how close on average a region's outward investment portfolio share in another region is to the other region’s weight in the world.
This leads to the following index of system-wide outward diversification for the EU (see the Annex to this column for a technical treatment).
We use data on cross-border banking claims to assess the systemic exposures of the EU (Schoenmaker and Wagner, 2013). Figure 1 contrasts the actual percentage of outflows of the EU vis-à-vis a non-EU country or region, relative to the benchmark portfolio allocation where assets are allocated proportionally to the size of a country’s banking system (denoted with ‘CAPM’ in the figure). It can be seen that the allocation to the US is much larger than justified by the size of the US. This overexposure is partly because European banks favour a large presence in the major markets of the US. Moreover, some of the larger EU banks have acquired regional banks in the US.
Moving to the emerging markets, European banks have very few cross-border claims on China, which is underweighted in the EU portfolio. This underrepresentation can be explained by entry restrictions and the lack of marketable securities in China. Looking more widely at some of the main emerging markets, the actual investment in India, Brazil and Russia are close to the optimal portfolio allocation.
Figure 1. Outflow shares of the EU banking sector
Note: This figure illustrates the diversification of the outflow shares of the EU27 banking system to some major economies. CAPM refers to the outflow shares according to the Capital Asset Pricing Model; Diff refers to the difference (or deviation) from the CAPM; Actual refers to the actual outflow share of the EU27 to a particular country.
Policymakers are slowly adopting macroprudential tools in the aftermath of the financial crisis. Adding to the tool set, we propose system-wide measures to assess the position of a region’s banking system towards other regions. This measure allows macroprudential authorities to detect overexposures to certain regions or groups of countries. In particular, it can be used by the ESRB to identify exposures of the European banking system to emerging markets. Our investigation shows that there are no overexposures, but a more refined and up-to-date investigation is recommended.
The ratio of the EU’s outward investment in another region j relative to the EU 's total outward investment should ideally be equal to the share a of region j's assets in the combined assets of all other non-EU regions. An index of the effectiveness of diversification in outward integration can then be constructed by looking at how close on average a region's outward investment portfolio share in another region is to the other region’s weight in the world.
This leads to the following index of system-wide outward diversification for the EU:
where the first term denotes total outward investment f of the EU in region/country j and the second term the share a of region/country j assets in world assets (excluding the EU). The term
thus gives us the deviation of the actual allocation of EU assets to region/country j from the ideal one. The system-wide index will be one if diversification is perfect and zero if investments are spread in the lumpiest fashion.
Brunnermeier, M, A Crockett, C Goodhart, A Persaud and H Shin (2009). “The Fundamental Principles of Financial Regulation”, 11th Geneva Report on the World Economy, ICMB, Geneva, and CEPR, London.
Markowitz, H (1952), “Portfolio selection”, Journal of Finance 7: 77-91.
Schoenmaker, D and W Wagner (2013), “Cross-Border Banking in Europe and Financial Stability”, International Finance 16: 1-22.