Determinants of Financial Cycle Correlations in Selected EU Member States

The recent financial crisis illustrated that more attention should be given to the dynamics of the financial cycle and the interactions with the business cycle. The central aim of the study is to assess the driving factors contributing to the correlations and contagion effects between business and financial cycles in selected EU states. For the empirical approach, we use frequency filtering methods and spillover analysis to track correlation and contagion. We measure both financial cycle correlation and spillover factors by looking at trade links, systemic risk episodes and bilateral financial claims. An important result of the paper is that financial cycle correlation is significantly influenced by business cycle correlation, but also by the overlap of financial stress episodes. With regard to the spillover effects between financial cycles, we find that they are strongly influenced by business cycle and financial stress spillovers, as well as by trade linkages and bilateral financial claims. Both in the case of the spillover regression model and in the case of the regression model on correlations, the most significant factors for the links between financial cycles are the business cycles and the financial stress indices. The policy implications for macroprudential authorities entail taking into account cross-border effects and spillovers when implementing instruments for taming the financial cycle.