Channels of Risk Sharing in the Eurozone: What Can Banking and Capital Market Union Achieve?

Risk sharing in the EMU collapsed during the eurozone crisis. We show that one important reason for this was that there was too little direct (i.e. bank-to-real-sector) cross-border banking integration and too much interbank integration. Interbank integration leaves firms and households fully exposed to idiosyncratic banking sector shocks and therefore does not provide risk sharing benefits during financial crises. Conversely, direct banking integration helps risk sharing by allowing the real sector to diversify its funding sources. We find that equity market integration (‘capital market union’) and (direct) banking integration (‘banking union’) are complements: firms’ access to cross-border credit helps stabilize labor income and investment in the face of country-specific shocks while making firms’ profits more volatile. Better equity market integration then contributes to internationally diversifying these increased fluctuations in profits.