Consumption smoothing and the role of banking integration in the euro area

Members of a currency union lose their capacity to adjust to idiosyncratic shocks via nominal exchange rate adjustments or monetary policy actions. However, a well-designed currency union strengthens their opportunities for cross-border private risk sharing. Depending on the nature of the shock, several private risk-sharing mechanisms exist, such as the cross-border flow of funds and income from assets held abroad. This section investigates to what extent cross-border bank sector integration helped smooth private consumption in the face of transitory shocks to household income since the euro was launched. The empirical analysis makes a distinction between direct and indirect bank integration. The former relates to direct interaction between foreign banks and domestic households, the latter to the borrowing and lending between foreign and domestic banks (with only domestic banks interacting with domestic households). The econometric analysis suggests that cross-border banking channels provided a useful countercyclical impulse to consumption over the sample period, smoothing up to half the negative income shocks. This smoothing effect, which can be large in principle, depends on the level of banking integration, which has declined in the wake of the global financial crisis. These findings provide useful policy lessons and underscore the need for further reforms to complete the economic and monetary union (EMU) architecture. This could give cross-border private risk sharing a more sustainable footing.