CURRENCY UNION WITH OR WITHOUT BANKING UNION

• Author: Régis Breton,Vincent Bignon,Mariana Rojas Breu
• Published date: 01 May 2019
• DOI: http://doi.org/10.1111/iere.12373
• Date: 01 May 2019

INTERNATIONAL ECONOMIC REVIEW

Vol. 60, No. 2, May 2019 DOI: 10.1111/iere.12373

CURRENCY UNION WITH OR WITHOUT BANKING UNION∗

BYVINCENT BIGNON,R

´

EGIS BRETON,AND MARIANA ROJAS BREU1

Banque de France, France, and CEPR, U.K.; Banque de France, France; Universit´

eParis

Dauphine, PSL University France

We build a symmetric two-country monetary model with credit to study the interplay between currency

integration and credit markets integration. The currency arrangement affects credit availability through default

incentives. We capture credit markets integration by the extra cost incurred to obtain credit for cross-border

transactions and, with the euro area context in mind, label as banking union a situation where this cost is low. For

high levels of the cross-border credit cost, currency integration may magnify default incentives, leading to more

credit rationing and lower welfare. The integration of credit markets restores the optimality of the currency

union.

1. INTRODUCTION

This article constructs a model to analyze whether the desirability of a currency union depends

on the degree of credit market integration across state borders.

The unification of banking markets is an overlooked issue of academic discussions on the

design of monetary unions. This stands in contrast with historical experience. In the two promi-

nent examples of monetary unions—the U.S. dollar and the euro—the initial design defined

common rules governing the legal tender and endowed a single organization with the right to

issue currency. Bank regulation and supervision originally remained in the state domain. Both

unions ended up fostering greater credit market integration across states and devolved most of

the banking regulation and supervision to the federal authorities.2Within the European Union

today, this policy agenda is being implemented under the label “banking union.”3This article

suggests that these policy initiatives did not occur by chance, but instead that in a low inflation

∗Manuscript received December 2015; revised October 2017.

1For helpful comments we thank Guido Menzio (the editor), three anonymous referees, Viral Acharya, Philippe

Andrade, David Andolfatto, Luis Araujo, Valerie Bencivenga, Aleksander Berentsen, Renaud Bourl`

es, Jean Cartelier,

Laurent Clerc, Michael Bordo, Hubert Kempf, Anne Le Lorier, Antoine Martin, Julien Matheron, Raoul Minetti,

Benoit Mojon, Borghan Narajabad, Ed Nosal, R´

egis Renault, Albrecht Ritschl, Guillaume Rocheteau, Julia Schmidt,

Jocelyne Tanguy, Xavier Timbeau, Chris Waller, Eugene White, and seminar participants at SKEMA Business School,

Basel Universit¨

at, Banque de France, Banco Central de la Rep´

ublica Argentina, Universit´

e Paris Nanterre, Universit´

e

Paris 2, Universit´

e de Cergy, Centre Cournot, OFCE, the 2013 French Economic Association Meeting, the 2013 SAET

Conference, the 2013 Asociaci´

on Argentina de Econom´

ıa Pol´

ıtica, the 2014 Royal Economic Society Meeting, the

2014 Journ´

ees LAGV, the 2014 IFABS Conference, the 2014 Chicago Fed Summer Workshop in Money, Banking

and Finance, the 2014 London MMF Conference, the 2014 Vienna FIW Conference, the 2015 ASSA–AEA Meeting,

the 2nd African Search and Matching Workshop, the OeNB Conference “Towards a Genuine Monetary Union,” and

the 12th Vienna Macro Workshop. The views expressed herein are those of the authors and not necessarily those of

the Banque de France or the Eurosystem. Please address correspondence to: Mariana Rojas Breu, Universit´

eParis

Dauphine, PSL University, Place du Mar´

echal de Lattre de Tassigny Paris Cedex 16, Ile De France 75775, France.

Phone: +33144054665. E-mail: mariana.rojas-breu@dauphine.fr.

2In the 19th century, U.S. periodic systemic banking crises triggered political discussions questioning the organization

of monetary issuance (Rousseau, 2013). Differences in regulatory frameworks during the National Banking Era of 1865–

1913 caused credit market distortions that “stimulated the public to press for currency and banking reform” (White,

1982).

3James (2012) documents that integration of banking markets was considered as an important dimension in the

discussions of monetary integration in Europe as early as the 1970s. Political support eventually came up following the

European sovereign debt crisis.

965

C

(2018) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

966 BIGNON,BRETON,AND ROJAS BREU

environment, credit market integration across states is a requisite to reap the gains of a unique

currency.

The issue is topical today in the euro area where credit markets remain imperfectly integrated

along states’ borders. The cross-border financing of firms and households represents a small

fraction of total financing to nonbank entities. For example, the share of cross-border bank

lending to nonbank entities across member states has varied between 3% and 6% since the

creation of the euro. Recent policy discussions on the sustainability of the European monetary

union have revealed that there is no consensus on whether more integration of credit and

financial markets occurring through an increase of cross-border lending would be beneficial

to the performance of euro area economies. Federal institutions—the European Central Bank

(ECB) and the European Commission—have supported policies fostering integration of those

markets, including retail finance, in order to complete monetary unification. In the words of the

ECB President M. Draghi, the insufficient credit market integration in the euro area is related

to “hidden barriers to cross-border activity linked to national preferences” (Draghi, 2014b).4A

contrasting standpoint in the policy debate defends instead greater credit market segmentation

across member states, with the view that currency arrangements and financial market structures

are to a large extent two independent matters (Cerutti et al., 2010).

To analyze the interplay between currency and credit market integration, we develop a

symmetric two-country model with currency and bank credit. Agents are entrepreneurs who

alternate between buying inputs and selling goods. They use currency to purchase inputs.

Bank credit provides insurance against individual productivity shocks that cannot be efficiently

insured by cash holdings. Entrepreneurs can borrow from banks to relax their cash constraint.

By lending out all the cash received in deposits, banks effectively redistribute cash according to

agents’ current transaction needs. Lending is potentially limited by the fact that agents cannot

commit to repay their debt. Banks impose borrowing limits and use the threat of exclusion from

future access to the banking system to sustain debt repayment.

An entrepreneur produces with either foreign or domestic input. Her production function is

such that she is sometimes more productive using the foreign instead of the domestic input. But

the cost of credit may be more expensive for cross-border purchases. In choosing which input to

use, she thus faces a trade-off between the efficiency gain of purchasing abroad versus the higher

cost of debt to finance foreign purchases. Throughout the article we refer to this extra cost as

the cross-border credit premium. The introduction of this premium is intended to capture in a

stylized manner various institutional frictions that may plague the efficiency of the use of cross-

border credit—such as the cost of cross-jurisdiction collateral seizure, the inter-operability cost

of using multi-platform payment systems or instruments, or the cost of sharing information on

borrowers’ creditworthiness.5The combination of those costs jointly determines the degree of

integration of inter-state credit markets. In turn, the lack of integration of cross-border credit

limits cross-border trade and ultimately triggers a home bias in spending decisions.

To evaluate the interplay between the lack of credit market integration and the monetary

regime, we compare two monetary arrangements: a single currency regime and a “one country–

one currency” regime. The only difference between the two regimes lies in the costs of converting

currencies, and we ask whether the case with strictly positive conversion costs is dominated in

terms of welfare by a currency union. We embed those features into the framework developed

by Lagos and Wright (2005), Rocheteau and Wright (2005), and Berentsen et al. (2007), but

we believe that the result would go through in other settings. Given our emphasis on monetary

4See also Constˆ

ancio (2014). The trend toward the ring-fencing of banking activities at the state level has been

reversed by the devolution of the supervision of banks to the ECB in November 2014. In this respect, a stated objective

of the ECB is that “a Spanish firm should be able to borrow from a Spanish bank at the same price at which it would

borrow from a Dutch bank” (Draghi, 2013).

5The level of cross-border credit to nonfinancial agents may also depend on other factors, such as the knowledge

of specifics of local markets, the role of relationship-based information, the degree of harmonization across state

bankruptcy legal procedures, and the automaticity of enforcement of cross-border foreclosure procedures.

CURRENCY UNION WITH OR WITHOUT BANKING UNION 967

versus credit integration, our modeling approach has the advantage of allowing for a precise

distinction between money and credit.

Our analysis delivers two sets of results.

The first set of results defines the conditions for the optimality of a currency union. We show

that with sufficiently integrated credit markets, a unique currency is always optimal. When

the cross-border credit markets are imperfectly integrated, a unique currency is optimal if the

borrowing constraint is not binding, which occurs when inflation is high enough. A regime of

separate currencies may be preferred for a low level of credit market integration if the borrowing

constraint is binding, which occurs if inflation is low enough.

The intuition for potential welfare gains associated with a breakup of a monetary union

is as follows: When credit market integration is imperfect, the reduction in conversion costs

associated with a single currency may worsen default incentives on bank loans. Given the

cross-border credit premium, the wedge between the cost of financing foreign versus domestic

purchases induces borrowers—agents with no record of default—to be biased toward domestic

goods. Instead agents who have defaulted and lost access to credit—something that does not

happen on the equilibrium path—are not impacted by the cross-border credit premium. Unlike

agents with access to credit, agents who have defaulted are not home biased since they make

their purchase decisions solely based on inputs’ relative productivities. Therefore, positive

conversion costs can make default less attractive, as they affect defaulters more severely than

nondefaulters, thereby relaxing borrowing constraints and allowing for a higher amount of

credit in equilibrium. By contrast, when financing conditions are the same for domestic and

cross-border purchases, there is no home bias, and a conversion cost between currencies does

not attenuate default incentives.

The second set of results characterizes how credit varies with the cross-border premium

when there is credit rationing. We first show that for both monetary regimes, the volume of

credit is monotonically decreasing in the cross-border credit premium. The logic is that a higher

cross-border credit premium reduces the value of maintaining future access to bank credit.

This negatively impacts repayment incentives and results in a lower volume of credit. We then

investigate how the premium has a differential impact across monetary regimes. We show

that credit crunches—defined as a reduction in the quantity of credit caused by a substantial

increase in the cross-border credit premium—are sharper in a currency union than in a regime

of separate currencies. The intuition is that by inducing a sufficiently strong increase in home

bias, an increase in the cross-border credit premium can trigger the positive effect of conversion

costs on repayment incentives, which ultimately outweighs the negative impact of conversion

costs on trade.

These results have implications for the current policy debate on the architecture of the

euro area. Our focus on stationary equilibrium highlights the long-term (structural) ingredients

needed for a sustainable currency union and independently of the design of the tools tailored to

cope with financial crises. The policy agenda of the European Commission aims at deepening

credit market integration and is negotiated under the headings “banking union” for banking

matters and “capital market union” for direct finance matters; see Valiante (2016). The model

suggests that in a low inflation economy deeper banking and capital market integration across

member states improves the efficiency of the currency union by reducing the incentives to

default on credit and thereby supporting a higher level of both credit and welfare.

1.1. Credit Market Integration in the Euro Area. Our article is partly motivated by the situ-

ation of the euro area characterized by a level of cross-border credit integration that has varied

substantially over the last 30 years. European credit markets were segmented along state bor-

ders before the creation of the euro. With the prospects of the creation of the monetary union

in 1999, various policy initiatives were taken during the 1990s to promote a single European

financial and credit market (James, 2012; ECB, 2007, 2012). As a result markets became more

integrated and credit activity increased (Allen et al., 2011). The money market and the govern-

ment bonds market became fully integrated, and the degree of integration of corporate bonds