Financial market fragmentation and monetary transmission in the euro area: what do we know?

This policy contribution was prepared for the Committee on Economic and Monetary Affairs of the European Parliament (ECON) as an input for the Monetary Dialogue of 28 November 2016 between ECON and the European Central Bank (http://www.europarl.europa.eu/committees/en/econ/monetary-dialogue.html). Copyright remains with the European Parliament at all times.

Abstract

We provide a survey on the literature examining financial market fragmentation in the euro area and discuss the policy options how to reduce it. The fragmentation has increased markedly since the outbreak of the global financial crisis in 2007. It declined somewhat from late 2012 onwards, but is still above the pre-crisis level. Interest rate pass-through has become less efficient primarily because of increased mark-ups and, to a certain extent, the lower responsiveness of bank interest rates to policy rates. The effectiveness of interest rate pass-through has become more heterogeneous across euro area countries, making a common monetary policy more difficult. The unconventional monetary policy conducted by the European Central Bank has reduced financial market fragmentation notably; however, this policy was not without side effects. Enhancing financial and fiscal stability in the euro area is key for the efficient functioning of the monetary transmission mechanism.

Keywords:

• financial market fragmentation
• monetary transmission
• European Central Bank

AMS Subject Classifications:

• E52
• E58
• G18

Acknowledgement

We thank two anonymous referees, Michal Franta, Chris Hartwell, Ales Marsal, Jakub Seidler and Borek Vasicek for helpful comments. We acknowledge the support from the Grant Agency of the Czech Republic 16-09190S. The views expressed here are those of the authors and not necessarily those of the authors are affiliated with.

Notes

This policy contribution was prepared for the Committee on Economic and Monetary Affairs of the European Parliament (ECON) as an input for the Monetary Dialogue of 28 November 2016 between ECON and the European Central Bank (http://www.europarl.europa.eu/committees/en/econ/monetary-dialogue.html). Copyright remains with the European Parliament at all times.

1. Financial market integration is another term often used in this regard. Researchers typically refer to financial market integration as the opposite of financial market fragmentation. Sometimes the term financial market de-integration is used instead of fragmentation.

2. However, Bonin, Hasan, and Wachtel (2005) show that the foreign bank entry to the central and eastern European countries improved efficiency and performance of domestic banks.

3. Given that monetary policy rates change in discrete steps, researchers typically use short-term money market rates instead of monetary policy rates in the regression analysis, assuming that policy and money market rates co-move strongly. However, this co-movement became somewhat weaker during the crisis, see von Borstel, Eickmeier, and Krippner (2016).

4. Furceri and Zdzienicka (2015) propose a supranational fiscal stabilization mechanism in the euro area in order to curb the impact of recessions on individual countries, given that individual countries (especially those with high debt and fiscal deficits in good times) are constrained by the Stability and Growth Pact. An alternative to fiscal stabilization would be a market-based solution via an integrated capital market in the euro area.