The intertwining of financialisation and financial instability

This paper aims to quantify the link between financialisation and financial instability, controlling for the financial and macroeconomic environment. Our main identification assumption is to represent these two concepts as a system of simultaneous joint data generating processes whose error terms are correlated. Based on panel data for EU countries from 1998, we test the null hypotheses that financialisation positively affects financial instability -a vulnerability effect- and that financial instability has a negative effect on financialisation -a trauma effect-, using Seemingly Unrelated Regressions and 3SLS. We find a positive causal effect of credit/GDP on non-performing loans - a vulnerability effect- in the EU as a whole, in the Eurozone, in the core of the EU but not at its periphery, and a negative effect of non-performing loans on credit/GDP - a trauma effect - in all samples. Even when relaxing our identification assumption, both opposite effects hold.