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In the context of monetary union, there are two objectives of a single market in capital. The first is to improve what economists call allocation – that is, credit is allocated efficiently and without reference to location. The second is to improve diversification, i.e. financial markets are integrated in such a way as to help companies and households cushion local shocks. In this sense, it is complementary to the single market in goods and services, which also raises allocative efficiency and may make local shocks less likely through trade integration.
There are some academics, however, who argue that the single market in goods and services may in time make local shocks more likely by increasing regional specialisation. If this is correct, completing the single market in capital becomes even more essential for the euro area: the greater the risk of local shocks, the greater the need for shock absorption through capital markets. In other words, the single market in capital is not a luxury, but an essential stabilising force within monetary union. It is essential for the euro to be stable, and for it to deliver its full effects in terms of growth and jobs.
So how do we currently fare in achieving the two objectives of the single market, allocation and diversification?
Allocation
Looking at credit developments in the euro area, in my view we still have a way to go to separate allocation from location. There are two ways in which I see that location still matters for credit: via the location of borrowers and of lenders. First, in the euro area today it is the location of borrowers, rather than their creditworthiness per se, that matters most for access to finance, in particular for SMEs. Credit supply in the euro area as a whole is most likely sufficient to meet aggregate credit demand. The problem is that cross-border frictions and high levels of uncertainty prevent credit markets from clearing. In a true single market, a creditworthy SME that could not borrow from a domestic bank would borrow directly from a bank located in another member state instead. Thus, the more efficient supplier would take market share at the expense of the less efficient one. But the mismatch between credit conditions in the euro area core and periphery shows this is not the case.
The second way in which location can affect allocation – the location of lenders – matters to the extent that non-economic factors influence banks’ business decisions. One dimension to this issue is the connection between local banks and local interests. There is intrinsic value for retail banks in being physically present in local markets as it lowers the costs of monitoring. Yet we also know there is a risk that local banks can become engaged in so-called "connected lending", which tends to be inefficient. Research suggests that in this context retail banking integration – in the form of cross-border M&A – can improve allocative efficiency by increasing the distance between the main shareholders and management of a bank and the vested interests in the country where the bank operates.
Diversification
Turning to diversification, we see a similarly incomplete picture as for allocation. Most studies on risk-sharing within the euro area suggest that financial markets in the euro area do not provide much cross-border insurance. Indeed, a recent study by Bruegel found that, during the crisis, credit and capital markets absorbed only about 10 per cent of the shock to GDP in net terms. By contrast, in the US it has been estimated that capital and credit markets smooth around two-thirds of a given shock.
In my view, on top of the lack of cross-border bank lending, the problem stems from the underdevelopment of two cross-border risk-sharing channels: private ownership of financial and non-financial firms and private insurance against banking crises.