Monetary Union with a Single Currency and Imperfect Credit Market Integration

Abstract

This paper shows that currency arrangements impact on credit available through default incentives. To this end we build a symmetric two-country model with money and imperfect credit market integration. With the Euro Area context in mind, we capture differences in credit market integration by variations in the cost for banks to grant credit for cross-border purchases. We show that for a high enough level of this cost, currency integration may magnify default incentives, leading to more stringent credit rationing and lower welfare than in a regime of two currencies. The integration of credit markets restores the optimality of the currency union. Abstract This paper shows that currency arrangements impact on credit available through default incentives. To this end we build a symmetric two-country model with money and imperfect credit market integration. With the Euro Area context in mind, we capture differences in credit market integration by variations in the cost for banks to grant credit for cross-border purchases. We show that for a high enough level of this cost, currency integration may magnify default incentives, leading to more stringent credit rationing and lower welfare than in a regime of two currencies. The integration of credit markets restores the optimality of the currency union. JEL

Banking union: Mind the gaps

“…The first weakness is the risk imposed on the real economy by the lack of integration of European credit markets. The lack of integration may threaten financial stability either by distorting the allocation of funds among countries (Lane, 2009;Kalemli-Ozcan, 2009) or by increasing the default risk and hence create more credit rationing (Bignon, Breton and Rojas Breu, 2015). Empirically, the wave of Texan banks failures that followed the 1986 reverse oil shock (O'Keefe, 1990) shows the danger associated with the lack of sectorial diversification but it also exemplifies how the lack of geographic diversification creates a strong correlation between loan portfolios, making banks vulnerable to a common exposure to a macroeconomic shock.…”

“…This was especially pervasive during the 19 th century but is still at work today, as shown by Agarwal, Lucca, Seru and Trebbi (2012). The impact of this leniency bias on the sustainability of monetary union may be problematic if it created an asymmetry between the ECB-supervised banks and those supervised at the domestic level, as shown by Bignon, Breton and Rojas Breu (2015).…”