1.   The Determinants of Cross-Border Lending in the Euro Zone The 14th Dubrovnik Economic Conference June 26-27, 2008 Sylvia Heuchemer Cologne University of Applied Sciences Stefanie Kleimeier (not present) Maastricht University and METEOR Fellow Harald Sander Cologne University of Applied Sciences, and METEOR Fellow

2. 2 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Introduction (1) European financial market integration has made a big leap forward. However, retail banking is lagging far behind, though recently gaining some momentum. We explore the geography of cross-border lending in the euro zone by means of a gravity approach in order to:  identify trade-theoretic determinants of cross-border lending  identify important drivers of and barriers to integration  special focus on exploring the role of cultural and political differences

3. 3 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Introduction (2) Gravity models have recently been used in explaining cross-border finance… (e.g. Guiso,Sapienza & Zingales 2005, Blank & Buch 2006) …and highlighted the limiting role of cultural and political factors in economic exchange (Guiso, Sapienza & Zingales 2005, Heuchemer & Sander 2007, Kalemli-Ozcan & Sørensen 2007) Our approach innovates on:  using a non publicly available bilateral data on cross-border loans for the euro zone  adapting a trade-theoretically-augmented gravity model to cross-border lending  modeling cultural and political differences in a gravity approach

4. 4 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Data Bilateral cross-border loans Annual outstanding volume from 1999-2006 Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain  except loans to customers in Lux and Por More than 800 countrypair-year specific observations

5. 5 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander - Increase in banking market integration - Lending is right-skewed, indicating that lending activities are concentrated in a few countries Cross-border loans more than doubled Data

6. 6 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Methodology (1) Gravity models have been successfully applied for explaining transactions over space, mainly trade in goods The canonical gravity model explains trade flows between two countries as a function of  their respective economic masses (GDP) and  the geographical distance separating them - as a proxy for all information and transaction costs

7. 7 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Methodology (2) Augmented gravity models  are micro-founded by adapting them to trade theories (e.g. Anderson 1979, Bergstrand 1985 & 1989 Deardorf, 1989, Anderson & van Wincoop 2003, Baltagi et al. 2003) Size (sum of GDPs)  “new trade theory” Similarity (of GDP)  “new trade theory” Relative per-capita income  Ricardo-HOS-theory vs. Linder  include additional trade impeding or trade promoting factors as proxy for information and transaction cost distance, common border, language alternative measures of cultural distances (“Hofstede”, trust to/trust from, differences in trust levels, legal system origin) Differences in governance quality

8. 8 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Methodology (3) Augmented gravity model adjusted to banking market analysis: With X ijt : cross-border loans from bank country to customer country at time t Size: sum of the GDPs of the trading partner (“new” trade theory)

9. 9 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Methodology (3) Size: sum of the GDPs of the trading partner (“new” trade theory) Augmented gravity model adjusted to banking market analysis: With X ijt : cross-border loans from bank country to customer country at time t Similar: similarity of the size of the financial sector (“new” trade theory)

10. 10 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Methodology (3) Size: sum of the GDPs of the trading partner (“new” trade theory) Augmented gravity model adjusted to banking market analysis: With X ijt : cross-border loans from bank country to customer country at time t Similar: similarity of the size of the financial sector (“new” trade theory) REL: indicator for relative financial development (“old” or “new” trade theory)

11. 11 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Methodology (3) Augmented gravity model adjusted to banking market analysis: With X ijt : cross-border loans from bank country to customer country at time t Size: sum of the GDPs of the trading partner (“new” trade theory) REL: indicator for relative financial development (“old” or “new” trade theory) Similar: similarity of the size of the financial sector (“new” trade theory) Distance: geographical distance between two countries Border: dummy variable that is 1 if two countries share a common border and 0 otherwise Y ijt : additional factors possibly influencing cross-border lending

12. 12 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander 1.Static Fixed Vs Random Effects Estimation 2.Static Vs Dynamic Fixed Effects Estimation  habit persistence may be likely in banking (switching and information costs) 3.Least Square Dummy Variables (LSDV) Estimation  Fixed effects estimations eliminate all time-invariant country- pair specific variables we are interested in  LSDV can remedy this, but we have to model the country- pair specific effects Estimation Procedure

13. 13 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Estimation Procedure 1: Fixed Vs Random Effects in Loan Markets None of the explanatory variables are statistically significant. Variation in cross-border loans can be explained by country- pair and time specific factors. 0,983

14. 14 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Hausman tests substantiate our choice of fixed effects model. Strong evidence for country-pair fixed effects Fixed time effects, capturing economic shocks and account for important regulatory and behavioral changes in the first years of the currency union Estimation Procedure 1: Fixed Vs Random Effects Estimation

15. 15 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Estimation Procedure 2: Dynamic Fixed Effects Habit persistence is likely in retail banking (information and transaction costs) Arellano-Bond Estimator

16. 16 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Data and Estimation Procedure 0,70 0,30 Model performs better without time dummies capturing regulatory changes. noyes Year dummies In order to capture regulatory changes

17. 17 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Data and Estimation Procedure noyes Year dummies Cross-border lending is habit persistent. 0,620,40 0,52 Cross-border lending is promoted by similarity of financial systems.

18. 18 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Estimation Procedure 3: LSDV Summary of the Fixed Effects Models  Strong evidence for country-pair FE  Habit persistence in loan markets Least Square Dummy Variables (LSDV) Estimation  Fixed effects estimations eliminate all time- invariant country-pair specific variables which we are interested in  LSDV can remedy this, but we have to model the country-pair specific effects

19. 19 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Estimation Procedure 3: LSDV Country-pair fixed effects are replaced by country-pair specific economic, cultural and political variables measured as Euclidean distance or as dummy variables with V as possible influencing factors on cross-border lending Country specific effects (country dummies) are included, capturing the effects of “multilateral resistance” Time dummies to account (at least partly) for habit persistence

20. 20 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Cultural proxies  Common language  Legal family (La Porta et. al)  Trust_from/Trust_to (Eurobarometer and Guiso et. al)  Trust levels (World Value Survey)  Overall cultural proxy based on Hofstede’s cultural dimensions (power distance, individualism, masculinity and uncertainty avoidance) Political proxies  Dimension of governance as defined by the World Bank (voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, control of corruption)  Overall political proxy based on all six dimensions Data (extended): Cultural and Political Proxies

21. 21 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander LSDV Results: Loans Basic Version Size 1,32 SIM 0,54 REL 0,43 R 2 0,830 Dist. -0,59 Border 0,54 Economic Geography Common borders increase cross-border banking by 71,6% Intra-industry trade - Product heterogeneity - Economies of scale „New“ Trade Theory„Old“ Trade Theory Comparative Advantages

22. 22 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander LSDV Results: Loans Impact of Cultural and Political Variables 0,11 Language Corruption -0,01 Gov. Effectivness Political Stability 0,03 -0,03 Reg. Quality Rule of Law -0,06 0,00 Statistically insignificant

23. 23 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander LSDV Results: Loans Impact of Cultural and Political Variables -0,24 Trust Legal Family Foreign Bank 0,11 0,66 Voice + Account. 0,09 Culture -0,34 Statistically significant

24. 24 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander LSDV Results: Loans Preferred Estimation R 2 0,844 Size 0,84 SIM 0,51 REL 0,54 Dist. -0,56 Border 0,48 Legal 0,55 Bank 0,13 Voice 0,14 Trust -0,24 Same legal system increases cross-border loans by 73,3% Cultural (rather than governance) factors play an important limiting role in banking market integration Influence of economic geography is slightly smaller Intra-industry trade Comparative advantages

25. 25 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Conclusion Cross-border lending is promoted by similarity of financial systems but… …differences in factor endowments and financial development still play a role. Cross-border lending is habit persistent. Strong geographic and cultural limits to full(er) integration  Distance and border effects  Differences in legal system origin  Cultural Differences (Trust)

26. 26 Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Research Challenges Ahead Towards a more theory-based measurement of cultural dimensions Exploring the interaction of the various concepts and proxies for information and transaction costs (also for trade, FDI, international finance) Efficient estimation of time invariant and rarely changing variables in gravity models with fixed effects (e.g. Hausman/Taylor, or more recently: Plümper/Troeger 2007)

27.   Thank you for your attention! Sylvia Heuchemer, Stefanie Kleimeier & Harald Sander Cultural and geographical factors remain for quite some time a barrier to banking market integration in the euro zone.