Financial Regulation, Integration and Synchronization of Economic Activity

We investigate the effect of financial integration on the degree of international business cycle synchronization. For identfication, we use a confidential database on banks' bilateral exposure over the past three decades and employ a novel bilateral country-pair panel instrumental vari- ables approach. First, we show that conditional on global shocks and country-pair fixed factors countries that become more financially integrated over time have less synchronized growth pat- terns, in line with the standard theories of output fluctuations. Second, to isolate the one-way impact of financial integration on output co-movement and account for measurement error in the financial integration measure, we exploit variation in the transposition dates of the European Union-wide legislative acts (the "Directives") from the Financial Services Action Plan (FSAP). These laws are designed to harmonize regulation of financial markets in the European Union. We find that increases in financial integration stemming from regulatory-legislative harmoniza- tion policies in capital markets are followed by more divergent output cycles, even when we condition on monetary unification. Our results contrast with those of the previous empirical studies. We reconcile the different results by showing that the earlier estimates suffer from the standard identification problems.