Essays on financial connectivity and stability

Abstract

This thesis investigates the structure of cross-border lending market by using network analysis and examines the relationship between financial connectivity and probability of systemic crises, controlling for macroeconomic variables. A country-level panel data set of BIS locational banking statistics for bank-to-bank and bank-to-non-bank cross-border lending markets including 177 countries is used in the analysis for the 1978-2016 period. Systemic crisis periods are retrieved from European Systemic Risk Board ( Lo Duca et al. (2017)) and Laeven and Valencia (2013, 2018). In the literature, there are two conflicting arguments on the relationship between financial connectivity and stability. On the one hand, it is argued that an increase in the level of financial connectivity enhances financial stability by allowing financial institutions to absorb the negative impacts of a shock among many counterparties through risk sharing. On the other hand, depending on the structure of the financial markets, it can also deteriorate financial stability by facilitating the spread of a shock from one institution to another, leading to an increase in systemic risk. We, first, examine cross-border bank-to-bank and bank-to-non-bank lending markets of 13 advanced economies. We find that an increase in financial connectivity reduces the probability of systemic crises. However, this effect is found to be mitigated or completely eliminated in credit boom and capital inflow upsurge periods in both lending markets. Second, we examine European bank-to-bank and bank-to-non-bank cross-border lending markets comprised of 25 countries, during 1978-2016 period, as it allows us to test the effect of the level of financial integration measured by the level of financial connectivity on the probability of crisis. We find that while using the single currency, Euro, helps to improve the resiliency of EU in response to crisis in both networks, legislative-regulatory integration across member states without eliminating currency risk undermines the resiliency of the EU bank-to-bank lending network. During the excessive cross-border lending period, an increase in connectivity is found to raise the probability of crisis for both lending networks, regardless of the membership status. Finally, we extend our data set to 177 countries and examine the relationship between financial connectivity and stability in the global lending network. We find that in bank-to-bank lending network, an increase in global financial connectivity decreases the probability of crises, but this effect is found to be eliminated only in credit boom periods. On the other hand, an increase in local connectivity is found to be associated with an increase in the probability of crisis. This effect seems to be mainly driven by emerging countries, rather than advanced countries. In both lending markets we find that capital inflow periods do not affect the relationship between connectivity and probability of crisis. The findings suggest that policy-makers should design a financial market mechanism that can reduce risks associated with an increase in financial connectivity, while maintaining its benefits.