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Gravity in Bank Lending within the European Union

August 15, 2017

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects by students in the Class of 2017. The project is a required component of every master program.


Authors:

Saga Gudmundsdottir, Olafur Heidar Helgason, Moritz Leitner, Clíona McDonnell and Alexander Schramm

Master’s Program:

Master in Economics and Finance

Paper Abstract:

This paper investigates whether and how geographical distance matters for bank lending within and between countries in the European Union. We estimate gravity-type regressions in various specifications, incorporating novel econometric insights which have thus far not been applied in the context of bank lending. Using recently published, disaggregated data on banks’ credit exposures from the European Banking Authority, we find the elasticity of lending with respect to distance to be -1.42 in our main specification. Controlling for various factors, the negative relationship remains persistent. We argue that this relationship is largely attributable to information costs, though cultural and historical ties between countries, capital requirements, local competition and cross-border trade also play a role. The analysis highlights the enduring influence of factors which prevent full European financial integration.

Conclusions:

The broad narrative that emerges from our analysis is that a combination of deeply-entrenched and policy-based factors determine international bank lending. Firstly, issues that have historically either hindered or facilitated lending – the prohibiting effect of distance in gathering information about potential or current borrowers, and the ties between societies brought about by cultural closeness, trade or direct investment – remain significant predictors of banks’ current stocks of outstanding loans within the EU. Secondly, some of the issues that have recently been under close scrutiny by European policymakers – capital requirements and market competition – also impact lending decisions.
Our analysis has important implications. Although we have not tested directly for the current state of financial integration in the banking sector in the EU, our results imply that a borderless single market for bank loans has not yet been achieved. Despite the progression of financial market integration across the EU, distance continues to be a deterrent to international bank lending on the European level. While some of the underlying mechanisms, particularly cultural and historical ties, are difficult to address politically, others provide scope for intervention by policymakers seeking to further progress the European integration project.

Although technological advancements may have improved transparency and eased the procurement of information and communication between bank and client, it seems they have not yet eliminated information costs in banking. There is room for new technologies that would further reduce the cost of verifying and monitoring clients to allow banks to underwrite more loans internationally. Although it is beyond the scope of this paper to provide a normative analysis of optimal EU policy, we have shown that both government ownership of competing banks and differences in national capital requirements act as deterrents to lending. The key areas we have identified could be targeted to advance the goal of further financial integration in bank lending across the EU.

 

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