European Monetary and Finance systems powerpoint homework

you will have to read the following pdf file enclosed in the attachments, and make a power-point presentation of about 15 slides… The presentation will be about 20 mins. so you can make slides accordingly. The quality of the presentation will make up for 40 % of my marks. So it is very important to do it right.

you will have to read the following from the enclosed pdf

Integration of the European Money Markets

[European Central Bank (2005), pp 3 – 5, 11, 14 n.]

pages 3 to 5 of the pdf file … and page 11, and page 14.

you will have to read those and make a ppt explaining about it. again the presentation has to be for 20 mins.. so make slides accordingly…around 15 slides… and also you will have to write me notes (explanation abt the content in the ppt), as i will need to present it in class.

I N D I C AT O R S O F F I N A N C I A L
I N T E G R AT I O N I N T H E E U R O A R E A

S E P T E M B E R 2 0 0 5

In 2005 all ECB
publications
will feature

a motif taken
from the

€50 banknote.

I N D I C AT O R S O F F I N A N C I A L
I N T E G R AT I O N I N T H E E U R O A R E A

S E P T E M B E R 2 0 0

Address
Kaiserstrasse 2

60311 Frankfurt am Main
Germany

Postal address
Postfach 16 03

60066 Frankfurt am Main
Germany

Telephone
+49 69 1344

Website
http://www.ecb.in

Fax
+49 69 1344 6000

Telex
411 144 ecb d

All rights reserved. Reproduction for
educational and non-commercial purposes
is permitted provided that the source is
acknowledged.

ISBN 92-9181-853-4 (print)
ISBN 92-9181-854-2 (online)

ECB

Indicators of financial integration in the euro area
September 2005

EXECUTIVE SUMMARY

The integration of Europe’s financial markets
is an issue of high importance for the
Eurosystem. This report provides an
assessment of the degree of integration in the
main financial segments of the euro area

namely the money, bond, equity and banking
markets. It is based on a set of financial
integration indicators that will be published
semi-annually on the ECB’s web site. The
report itself will be published annually, with
the aim of documenting and monitoring the
progress of financial integration in the euro
area. While this first release of these indicators
already covers many important dimensions of
financial systems, it is the intention of the

ECB

to further develop the analysis in the report and
the statistics in the future.

The available evidence suggests that the degree
of integration varies greatly depending on the
market segment. The unsecured money market
has been fully integrated since shortly after the
introduction of the euro. The repo market is
highly integrated albeit to a lower extent.
Government bond markets were significantly
integrated even before the start of EMU,
although some yield differentials remain. The
indicators for the corporate bond market,
which has grown considerably since the advent
of the single currency, point to a high degree of
integration. Progress has also been made in the
integration of euroarea equity markets, where
equity returns are increasingly determined
by common factors. Banking markets are
generally much less integrated.

1 INTRODUCTIO

A well integrated financial system increases
the efficiency of the euro area economy by
reducing the cost of capital and improving the
allocation of financial resources. It also
contributes to a smooth and effective
implementation of monetary policy throughout
the euro area. Moreover, given the strong
connections between financial integration and

financial stability, a deeper financial
integration may have a potential impact on the
stability of the whole financial system, an area
of great interest to central banks. All in all,
there is substantial evidence that financial
integration may ultimately support higher and
more sustainable economic growth through a
variety of channels. Against this background,
the ECB has taken a proactive stance towards
fostering European financial integration within
the limits of its capabilities and competence.

This report is a new initiative by the ECB. It
provides an overall assessment of the degree of
financial integration in the different financial
market segments of the euro area, ranging as
widely as from retail lending to wholesale
equity trading. It is based on a series of
indicators that will be regularly updated and
published on the ECB’s website.

The report will be produced on an annual basis
with the aim of monitoring the progress of
financial integration in the euro area. The range
of indicators used may be extended over time,
in line with improvements in data availability
and advances in research. While this first
report already focuses on a number of crucial
dimensions of financial systems, spanning
financial and credit markets, it is the intention
of the ECB to further develop the dataset in the
future. In particular, it is envisaged to add
indicators on some important underlying
factors of integration related to financial
institutions and market infrastructures.
Moreover, the ECB will strive to add
integration indicators for markets that could
not be covered in this edition due to their
relatively recent emergence.

1 For example, three different phenomena can be identif ied. One
is the degree to which the different national markets which
existed before the launch of the euro have integrated over time.
Another is the process by which new market segments
originating in a particular countr y or f inancial centre have
spread and integrated across Europe after the arrival of the
euro. And lastly, there are some important markets that came
into existence after the launch of the euro, but were integrated
from the outset. Two signif icant examples of the latter
phenomenon are the overnight index swap market and the
market for synthetic collateralised debt obligation (CDOs).
The initial set of indicators presented here does not yet cover
these two relatively young markets.

ECB c
Indicators of financial integration in the euro area
September 2005

The market for a given financial instrument is
considered fully integrated if all economic
agents with the same relevant characteristics
acting in that market face a single set of rules,
have equal access and are treated equally. This
definition underpins the measures proposed in
the report.2 Two broad categories of indicators
are considered: price-based indicators
and quantity-based indicators. Price-based
indicators measure discrepancies in asset prices
based on their geographic origin. In a perfectly
integrated market, prices of assets with similar
characteristics should mostly be influenced by
common euro area factors. Quantity-based
indicators are used to investigate the extent to
which investors have internationalised their
portfolios. They usefully complement price-
based indicators, as in financially integrated
markets investors will increase their holdings of
non-domestic assets to fully reap the benefits of
international diversification. The indicators are
either “computed” or “model-based”.

Computed

indicators such as standard deviations, ratios
etc., are summary measures of the underlying
data and are not model-specific, whereas the
other indicators are derived from econometric
models. Such model-based indicators have been
used when computed indicators do not allow a
disentangling of country effects. As these
estimates depend on a specific set of modelling
assumptions, they need to be interpreted with
caution. In the report, the focus is on euro-
denominated instruments, with particular
attention being paid to price differences across
euro area countries.

While analysing the developments in the
indicators over time, it is worth keeping in
mind that in some markets the progress in
financial integration per se is not easily
disentangled from the effects of the elimination
of exchange rate risk and the convergence of
inflation expectations across euro area
countries.

The report is structured as follows. The
following sections analyse money, bond,
equity and banking markets. Each section
presents an overall assessment of the current

degree of financial integration and discusses
the evolution of the indicators in more detail.
There aree two annexes to this report. Annex 1
contains all of the indicators while the
technical documentation for each indicator can
be found in Annex 2.

2 MONEY MARKETS

The available indicators for the euro area
money market point to an overall high degree
of integration. The unsecured money market
reached a stage of “near-perfect” integration
almost immediately after the introduction of
the euro. In addition, the repo market is highly
integrated albeit to a lower extent.

The money market, broadly defined as the
market for interbank short-term debt or
deposit, consists of various segments. The
financial integration of the money market can
be analysed on the basis of the dispersion of
lending rates offered by different banks in each
market segment. This section discusses
indicators for the unsecured interbank market
and the repo market. The data refer to actual
transactions or offered rates by banks included
in the panels for the EONIA (euro overnight
index average), the EURIBOR (euro interbank
offered rate) and the EUREPO (benchmark rate
for secured money market transactions in the
euro area).

Figures 1, 2 and 3 show the cross-country
standard deviation for the EONIA, EURIBOR
and EUREPO, respectively. According to
Figures 1 and 2, the cross-sectional standard
deviation of the EONIA and EURIBOR lending
rates across euro area countries plummeted to
close to zero following the introduction of the
euro and remained stable thereafter. All these
indicators paint a consistent picture of a highly
integrated unsecured money market.

2 For the economic and technical background to measures
proposed in this report, see L. Baele, A. Ferrando, P. Hördahl,
E. Krylova and C. Monnet (2004), “Measuring financial
integration in the euro area”, ECB Occasional Paper No. 14.

5
ECB c

Indicators of financial integration in the euro area
September 2005

Figure 3 shows the same type of indicator
as plotted in Figures 1 and 2 for the
1-month and 12-month EUREPO rate. The
behaviour of the 12-month EUREPO rate
indicator in particular is characterised by large
movements, in part reflecting the lower
liquidity of this market. The indicators suggest
that there is a relatively high degree of
integration also in the euro area repo market.

F i g u r e 1 C r o s s – c o u n t r y s t a n d a r d d e v i a t i o n
o f t h e a v e r a g e o v e r n i g h t l e n d i n g r a t e s
a m o n g e u r o a r e a c o u n t r i e s

(60-day moving average; basis points)

Source: European Banking Federation, ECB calculations.

100

150

200

0
50
100
150
200
250
300

1994 1995 1996 1997 1998

1999 2000 2001

2002 2003 2004 2005

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

0.0

0.5
1.0
1.5
2.0
2.5
3.0
3.5

1999 2000 2001 2002 2003 2004 2005

Source: European Banking Federation, ECB calculations.
0
50
100
150
200
250
300
0
50
100
150
200
250
300

1-month maturity

12-month maturity

1994 1995 1996 1997 1998 1999 2000 2001

2002 2003 2004 2005

1999 2000 2001 2002 2003 2004 2005
0

0.4

1.2

1.4

0.2

0.4

0.6

0.8

1
1.2
1.4

F i g u r e 2 C r o s s – c o u n t r y s t a n d a r d d e v i a t i o n
o f u n s e c u r e d l e n d i n g r a t e s a m o n g e u r o a r e a
c o u n t r i e s
(60-day moving average; basis points)

F i g u r e 3 C r o s s – c o u n t r y s t a n d a r d d e v i a t i o n
o f r e p o r a t e s a m o n g e u r o a r e a c o u n t r i e s

(60-day moving average; basis points)
Source: European Banking Federation, ECB calculations.
1-month maturity
12-month maturity

0
5

45
50

0
5

10
15
20
25
30
35

45
50

2002 2003 2004 2005
2002 2003 2004 2005
2.5
2.0
1.5
1.0
0.5
0.0
2.5
2.0
1.5
1.0
0.5
0.0

6
ECB c
Indicators of financial integration in the euro area
September 2005

3 BOND MARKETS

The available indicators show that with the
introduction of the euro and the removal of
exchange rate risk, government bond yields
have converged in all euro area countries and
increasingly tend to be driven by common
news. However, the importance of local factors
continue to have some influence. This may
partly be explained by differences in liquidity
and the availability of developed derivatives
markets tied to the various individual bond
markets. Additionally, bond yields in different
countries also reflect differences in perceived
credit risks. The impact of these factors,
however, should not be seen as an indication of
a lack of integration. The euro area corporate
bond market has grown considerably in recent
years. The available evidence suggests that
this market is already reasonably well
integrated.

3.1 GOVERNMENT BONDS
Measures of integration in government bond
markets are based on yield differentials with
respect to a benchmark bond (e.g., the German
bond for 10-year bonds and the French bond for
2- and 5-year bonds). Given comparable
maturities and other relevant characteristics,
yield spreads for government bonds can
provide a direct measure of the degree of
integration. A simple measure is to look at
developments in the standard deviation of these
spreads over time: the higher the degree of
integration, the lower the dispersion. In
assessing this indicator, it should be borne in
mind that movements related to changes in the
credit risk perceptions by the market do not
signal a variation in the degree of integration.
In order to address this problem, additional
indicators have been developed. Another
commonly used measure, referred to as “beta-
convergence”, is based on the economic
intuition that the more integrated the market is,
the more bond yields should react to common
factors instead of local factors.3

Figure 4 shows the evolution over time of the
standard deviations of government yield
spreads over German bonds (for 10-year bonds)
and French bonds (for 2- and 5-year bonds).
The figure shows a significant drop in these
indicators in the run-up to the EMU, which then
remain close to zero from 2001 onwards (the
year in which Greece joined EMU). The sharp
decline of these indicators signals that the euro
area government bond market has reached a
very high level of integration.

F i g u r e 4 S t a n d a r d d e v i a t i o n o f g o v e r n m e n t
b o n d y i e l d s p r e a d s f o r 2 – , 5 – a n d 1 0 – y e a r
m a t u r i t i e s

(yield dispersion in %)

Source: ECB.
Note: As a benchmark, the Ger man gover nment bond
yield is taken for the 10-year maturity and the French
gover nment bond yields are taken for 2- and 5-year
maturities. Greece enters the standard deviation
calculations for all maturities at the date of its entr y to
E M U.

2 year
5 year
10 year

0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5

1993 1994

1995 1996 1997

1998 1999 2000 2001 2002 2003 2004 2005

These conclusions are confirmed by the
indicators shown in Figure 5, concerning the
evolution of the beta-convergence. The plotted
“betas” represent the estimated correlation of
changes in the 10-year government bond yield
of a given country with changes in the German
10-year government bond yield. The betas
varied substantially up to 1998 and converged
afterwards towards 1, the perfect integration
level. Greek bond yields only converged after
2001.

3 An alternative widely used measure is the “sigma-
convergence”. This takes into consideration the evolution of
dispersions over time in a regression analysis.

ECB c

Indicators of financial integration in the euro area
September 2005

F i g u r e 5 E v o l u t i o n o f b e t a c o e f f i c i e n t s f o r
s o m e s e l e c t e d c o u n t r i e s

(10-year government bond yields; 18-month rolling
regression)

Source: ECB.
Note: Based on a model reg ressing national 10-year
gover nment bond yields on benchmark Ger man 10-year
gover nment bond yields.

0.85

0.95

1.00

1.05

1.10

1.15

0.85
0.90
0.95
1.00
1.05
1.10
1.15
2002 2003 2004 2005

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5
0.0
0.5
1.0
1.5
2.0
2.5

-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5

France
Greece
Italy
the Netherlands
Spain

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

3.2 CORPORATE BONDS
The yield on a corporate bond typically
depends on a number of factors, such as the
credit rating, time-to-maturity, liquidity and
cash-flow structure. With full integration, the
impact of these specific factors should be
identical across all countries. Using the same
set of specific factors, it is possible to obtain
measures of corporate bond market integration
by investigating whether or not risk-adjusted
yield spreads have a systematic country
component. In an integrated market, the
proportion of the total yield spread variance
that is explained by country effects should be
close to zero.

Following this approach the indicator shows
that the euro area corporate bond market is
quite well integrated. Country effects are seen
to explain only a very small proportion of the
cross-sectional variance of corporate bond
yield spreads (see Figure 6).4

4 It should be noted that the total explanatory power of the
underlying regression is relatively low. This is in line with
previous studies on the determinants of cor porate bond risk
premia.

F i g u r e 6 P r o p o r t i o n o f c r o s s – s e c t i o n a l
v a r i a n c e e x p l a i n e d b y v a r i o u s f a c t o r s

(percentages)

Source: Bloomberg and ECB calculations.

explained by regression
explained by common, maturity, coupon, liquidity
and sector effects
explained by rating effect
explained by country effect

-5

0
5

10
15
20
25
30
35
40

-5
0
5
10
15
20
25
30
35
40

1998 1999 2000 2001 2002 2003 2004

4 EQUITY MARKETS

The measures of euro area equity market
integration indicate a rising degree of
integration. First, since the end of 2000, the
advantages of a sector diversification seem to
have – for the first time in the last 30 years –
surpassed those of a geographical
diversification. Recent data show that this
reversal was short-lived but suggest increased
correlations of both country and sector
returns. Second, equity returns in the euro area
countries are increasingly determined by
common factors. However, there appears to
still be scope for further integration.

In an integrated equity market, country-
specific factors should be of less importance.
The more integrated the market, the greater the
benefits of diversification through sector-
based equity investment strategies rather than
through country-based ones. By comparing the
cross-sector dispersion with the cross-country
dispersion of equity returns, it is therefore
possible to derive indicators of financial
integration.

8
ECB c
Indicators of financial integration in the euro area
September 2005

F i g u r e 7 F i l t e r e d c o u n t r y a n d s e c t o r
d i s p e r s i o n s o f e u r o a r e a e q u i t y r e t u r n s

(percentages)

Source: Thomson Financial Datastream and ECB
c a l c u l a t i o n s .
Note: The f igure shows Hodrick-Prescott f iltered cross-
sectional dispersions of monthly euro area countr y and
sector equity retur ns.

country dispersion
sector dispersion

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
0

1
2
3
4
5
6
7
0
1
2
3
4
5
6
7

Figure 7 plots the country and sector
dispersions of monthly equity returns over
time. For nearly the whole sample, the country
dispersion has been higher than the sector
dispersion. To the extent that dispersion and
correlation are inversely related, this finding
suggests that a country diversification strategy
has been superior to a sector diversification
strategy for most of the time. The difference
between country and sector dispersions
narrowed in the late 1990s and the sector
dispersion has even slightly exceeded the
country dispersion from 2001 onwards,
suggesting a possible shift in the asset
allocation paradigm from country-based to
sector-based strategies. However, both country
and sector dispersions have strongly decreased
in the most recent years. Obviously, this
complicates an interpretation of the results in
terms of the advantage of sector diversification
relative to country diversification.

Alternative indicators of financial integration
in equity markets can be derived from factor
models. Under the assumption that equity
returns in the euro area countries react to a local
and a global factor (proxied, respectively by
shocks in aggregate euro area and US equity

markets), it is possible to estimate the intensity
(beta) with which euro area and global shocks
are transmitted to national equity markets. The
part of local return fluctuations that is not
explained by the common factors can be
interpreted as the reaction to purely local news.
Thus, a higher spillover intensity suggests a
higher degree of equity return co-movements
across countries (i.e. a higher integration).

Figure 8 shows that the average sensitivity to
common shocks has increased significantly
over the last decades, in particular as regards
euro area-wide return shocks. This can be
interpreted as an indication of increased
integration of euro area equity markets. It can
be noted, however, that the contemporaneous
increase in US shock spillover intensities
suggests that the increased integration may
also be a global phenomenon. In this context,
the slight decrease of US shock spillover
intensities and the continued increase of
euro area spillover intensities since the
establishment of the euro are worth observing.

It is also possible to look at the proportion of
the total domestic equity volatility that can be
explained by euro area-wide and US shocks

F i g u r e 8 E u r o a r e a a n d U S s h o c k s p i l l o v e r
i n t e n s i t y

Source: Thomson Financial Datastream and ECB
c a l c u l a t i o n s .
Note: For each period, the f irst column shows the
unweighted average intensity with which euro area-wide
equity market shocks, other than those from the United
States, are transmitted to local euro area equity markets.
The second column shows the unweighted average
intensity with which US equity market shocks are
transmitted to local euro area equity market retur ns.

euro area shock spillover intensities
US shock spillover intensities

0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9

1973-1985 1986-1991 1992-1998 1999-2005

9
ECB c

Indicators of financial integration in the euro area
September 2005

respectively (“variance ratios”). Ceteris
paribus, a higher variance ratio that can be
associated with euro area wide changes is an
indication of a more integrated euro area equity
market, signalling that national stock market
returns are increasingly driven by common
news. Figure 9 shows that the variance ratios

F i g u r e 9 P r o p o r t i o n o f v a r i a n c e i n l o c a l
e q u i t y r e t u r n s e x p l a i n e d b y e u r o a r e a a n d
U S s h o c k s
(percentages)

Source: Thomson Financial Datastream and ECB
c a l c u l a t i o n s .
Note: For each period, the f irst column shows the
unweighted average of the relative impor tance of euro
area-wide f actors, other than US equity market shocks,
for the variance in individual euro area countries’ equity
market retur ns (“variance ratio”). The second column
shows the unweighted average of the relative impor tance
of US equity market shocks for the variance in euro area
equity market retur ns.

euro area shocks
US shocks

1973-1985 1986-1991 1992-1998 1999-2005

5
10
15
20
25
30
35
40
0
5
10
15
20
25
30
35
40

have increased over the past 30 years with
respect to both euro area-wide and US shocks,
although the increase has been the strongest for
the former type of shocks. This suggests that
regional euro area integration has proceeded
more quickly than the world wide integration.
However, the still relatively low level of
variance explained by euro area wide factors
(about 35%) reveals that local shocks are still
relatively important, indicating that further
integration is possible.

5 BANKING MARKETS

The available evidence suggests that the euro
area banking market remains highly
fragmented, as indicated by a high cross-
sectional dispersion of the same types of
interest rates and low cross-border banking
activity. However, the euro area interbank
market has shown signs of increasing
integration.

Integration in the retail bank market can be
measured directly by looking at the dispersion
of interest rates on consumer credit, lending for
house purchase and deposits with agreed
maturity. Figure 10 suggests that cross-country

F i g u r e 1 0 C r o s s – c o u n t r y s t a n d a r d d e v i a t i o n
o f M F I i n t e r e s t r a t e s : l o a n s t o h o u s e h o l d s
a n d d e p o s i t s w i t h a g r e e d m a t u r i t y

Source: ECB.
Note: The measure is based on MFI interest rates on new
b u s i n e s s .

consumer credit
lending for house purchase
deposits with agreed maturity

0.0
0.2
0.4
0.6
0.8
1.0
1.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2

Jan. Mar. May July Sep. Nov. Jan. Mar. May Jan. Mar. MayJuly Sep. Nov.
2003 2004 2005

F i g u r e 1 1 MFI loans to non-MFIs: outstanding
amounts by residency of the counterparty as a share of
total loans granted by MFIs, excluding the Eurosystem
(percentages)

Source: ECB.
Note: This indicator displays the geog raphical
counter par ty diversif ication of loans g ranted by euro area
MFIs to non-MFI counter par ties resident in other euro
area countries and non-euro area EU Member States.

other euro area countries
rest of EU

Sep.
1997

Mar.
2005

Mar. Sep.
19

Mar. Sep.
1999

Mar. Sep.
2000

Mar. Sep.
2001

Mar. Sep.
2002

Mar. Sep.
2003

Mar. Sep.
2004

0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5

4.0

0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5

4.0

10
ECB c
Indicators of financial integration in the euro area
September 2005

Figure 12 MFI loans to MFIs: outstanding amounts by
residency of the counterparty as a share of total
loans granted by MFIs, excluding the Eurosystem
(percentages)

Source: ECB.
Note: This indicator displays the geog raphical
counter par ty diversif ication of loans g ranted by euro area
MFIs to MFI counter par ties resident in other euro area
countries and non-euro area EU Member States.

other euro area countries
rest of EU
Sep.
1997
Mar.
2005

Mar. Sep.
1998

Mar. Sep.
1999
Mar. Sep.
2000
Mar. Sep.
2001
Mar. Sep.
2002
Mar. Sep.
2003
Mar. Sep.
2004
0
5
10
15
20
25
0
5
10
15
20
25

Figure 13 MFI holdings of securities issued by non-MFIs:
outstanding amounts by residency of the issuer as a
share of total holdings, excluding the Eurosystem
(percentages)

Source: ECB.
Note: The indicator shows securities held by euro area
MFIs and issued by non-MFIs resident in other euro area
countries and non-euro area EU Member States.

other euro area countries
rest of EU
Sep.
1997
Mar.
2005
Mar. Sep.
1998
Mar. Sep.
1999
Mar. Sep.
2000
Mar. Sep.
2001
Mar. Sep.
2002
Mar. Sep.
2003
Mar. Sep.
2004
0
5
10
15
20
25
30
35
40
0
5
10
15
20
25
30
35
40

dispersions of bank interest rates have
remained relatively high (compared, for
example, with the government bond market)
since January 2003.5 However, this may not
only be due to an incomplete integration. The
ECB, together with the NCBs is undertaking a
comprehensive analysis of cross-country
interest rate dispersion.

Looking at the share of cross-border activity in
the total lending activity of MFIs, these
findings are broadly confirmed. Cross-border
retail bank lending activity in the euro area
remains very limited (around 3.5% of the total),
suggesting a fragmented retail banking market
(see Figure 11).

Although domestic loans still account for more
than 50% of the total, the euro area interbank
market has shown signs of increasing
integration as cross-border activity among the
euro area countries has increased substantially
(see Figure 12). Furthermore, the share of
MFIs’ holdings of non-domestic (euro area in
particular) securities in total holdings has
increased markedly in recent years, which
points to a higher degree of capital market
integration in the euro area (see Figure 13).

5 Data prior to 2003 could be shown once historical standardised
MFI interest rate data become available. Using unharmonised
data available up to January 2003, L. Baele, A. Ferrando,
P. Hördahl, E. Krylova and C. Monnet (2004) showed that
cross-country dispersions of bank interest rates have declined
somewhat since the early 1990s (partly due to the strong
convergence of inflation rates). Analogous to developments in
government bond yields, the declining trend has come to a halt
in recent years, which may point to a slowdown in the process
of integ ration in this market segment.

ECB c

Indicators of financial integration in the euro area
September 2005

Money market indicators

N Indicator Description Computed/model- Sources
based

Government bond market indicators

1
2
3
4
5
6
7

Computed
Computed
Computed
Computed
Computed

Model-based

Model-based
Model-based

EBF/ECB

EBF

EBF
ECB
ECB
ECB
ECB
ECB

Cross-country standard
deviation of the average
overnight lending rates
among euro area
countries

Cross-country standard
deviation of unsecured
lending rates among euro
area countries

Cross-country standard
deviation of repo rates
among euro area
countries

Standard deviation of
government bond yield
spreads for 10-year
maturity

Standard deviation of
government bond yield
spreads for 2-and 5-year
maturities

Evolution of
beta coefficients

Average distance of
intercept/beta from
values implied by
complete integration

Variance ratio

The measure is based on
average overnight rates
for each of the euro area
countries, as reported by
EONIA banks

The measure is based on
the unsecured 1- and
12-month lending
rates

Based on the quotes
reported by EUREPO
panel banks for 1- and
12-month repo rates

Based on euro area
country yields on
10-year government
bonds

Based on euro area
country yields
on 2- and 5-year
government bonds

Based on 18-months
rolling regression of
changes in country yields
for 10-year government
bonds with respect to
changes in yields on the
benchmark (German) 10-
year government bond

Based on the same model
as indicator 9

A N N E X 1 I N D I C A T O R S O F F I N A N C I A L
I N T E G R A T I O N

ECB c
Indicators of financial integration in the euro area
September 2005

Corporate bond market indicators

N Indicator Description Computed/model- Sources
based
9
10
11
Model-based
Model-based
Model-based

Bloomberg

Bloomberg
Bloomberg

Proportion of cross-
sectional variance
explained by various
factors

Estimated coefficients of
country dummies

Cross-sectional
dispersion of country
parameters

Based on the Merrill
Lynch EMU corporate
bond index. The measure
is derived by running a
regression of spreads
relative to a set of
variables including
rating

Based on the same model
as indicator 12

Based on the same model
as indicator 12
12

Model-based
Model-based
Model-based

Thomson Financial
Datastream

Thomson Financial
Datastream
Thomson Financial
Datastream

Filtered country and
sector dispersions of euro
area equity returns

Euro area and US shock
spillover intensity

Proportion of variance
in local equity returns
explained by euro area
and US shocks

Based on monthly
cross-sectional Hodrick-
Prescott filtered total
equity returns
on country and sector
indexes

The indicator is derived
from a model specifying
euro area-wide and US
(global) shocks to
estimate the average
sensitivities of country
returns to common
factors

The indicator is derived
from a model specifying
euro area-wide and US
(global) shocks to
estimate the proportion of
total domestic equity
volatility explained by
common factors

Equity market indicators

13
ECB c

Indicators of financial integration in the euro area
September 2005
N Indicator Description Computed/model- Sources
based

Banking market indicators

19
20
Computed
Computed
Computed
Computed
Computed
Computed
ECB
ECB
ECB
ECB
ECB
ECB

Cross-country standard
deviation of MFI interest
rates on loans to non-
financial corporations

Cross-country standard
deviation of MFI interest
rates on loans to
households and deposits
with agreed maturity

MFI loans to non-MFIs:
outstanding amounts by
residency of the
counterparty as a share of
total loans granted by
MFIs, excluding the
Eurosystem

MFI loans to MFIs:
outstanding amounts by
residency of the
counterparty as a share of
total loans granted by
MFIs, excluding the
Eurosystem

MFI holdings of
securities issued by
non-MFIs: outstanding
amounts by residency of
the issuer as a share of
total holdings, excluding
the Eurosystem

MFI holdings of
securities issued by
MFIs: outstanding
amounts by residency of
the issuer as a share of
total holdings, excluding
the Eurosystem

Based on MFI (monetary
financial institutions)
interest rate statistics

Based on MFI interest
rate statistics

Based on BSI (balance
sheet items) statistics

Based on BSI statistics

Based on BSI statistics
Based on BSI statistics

14
ECB c
Indicators of financial integration in the euro area
September 2005

M O N E Y M A R K E T
C h a r t 1 C r o s s – c o u n t r y s t a n d a r d d e v i a t i o n o f
t h e a v e r a g e o v e r n i g h t l e n d i n g r a t e s a m o n g
e u r o a r e a c o u n t r i e s
(60-day moving average; basis points)

Source: European Banking Federation, ECB calculations.
0
50
100
150
200
250
300
0
50
100
150
200
250
300
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1999 2000 2001 2002 2003 2004 2005

C h a r t 2 C r o s s – c o u n t r y s t a n d a r d d e v i a t i o n o f u n s e c u r e d l e n d i n g r a t e s a m o n g e u r o a r e a
c o u n t r i e s
(60-day moving average; basis points)

Source: European Banking Federation, ECB calculations.
0
50
100
150
200
250
300
0
50
100
150
200
250
300
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
1-month maturity
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1999 2000 2001 2002 2003 2004 2005
0
50
100
150
200
250
300
0
50
100
150
200
250
300
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
12-month maturity
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1999 2000 2001 2002 2003 2004 2005

15
ECB c

Indicators of financial integration in the euro area
September 2005

C h a r t 3 C r o s s – c o u n t r y s t a n d a r d d e v i a t i o n o f r e p o r a t e s a m o n g e u r o a r e a c o u n t r i e s

(60-day moving average; basis points)
Source: European Banking Federation, ECB calculations.
0
5
10
15
20
25
30
35
40
45
50

0
5
10
15
20
25
30
35
40
45
50

2002 2003 2004 2005
1-month maturity
0.0
0.5
1.0
1.5
2.0
2.5
0.0
0.5
1.0
1.5
2.0
2.5
2002 2003 2004 2005
0
5
10
15
20
25
30
35
40
45
50
0
5
10
15
20
25
30
35
40
45
50
2002 2003 2004 2005
12-month maturity
0.0
0.5
1.0
1.5
2.0
2.5
0.0
0.5
1.0
1.5
2.0
2.5
2002 2003 2004 2005

16
ECB c
Indicators of financial integration in the euro area
September 2005

G O V E R N M E N T B O N D M A R K E T
C h a r t 4 S t a n d a r d d e v i a t i o n o f g o v e r n m e n t
b o n d y i e l d s p r e a d s f o r 1 0 – y e a r m a t u r i t y

(yield dispersion in %)

Source: ECB.
Note: As a benchmark, the Ger man gover nment bond
yield is taken. Greece enters the standard deviation
calculations for all maturities at the date of its entr y to
E M U.

10-year maturity

0.0
0.5
1.0
1.5
2.0
2.5
0.0
0.5
1.0
1.5
2.0
2.5
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

C h a r t 5 S t a n d a r d d e v i a t i o n o f g o v e r n m e n t
b o n d y i e l d s p r e a d s f o r 2 – a n d 5 – y e a r
m a t u r i t i e s
(yield dispersion in %)

Source: ECB.
Note: As a benchmark, the yield on French gover nment
bonds is taken. Greece enters the standard deviation
calculations for all maturities at the date of its entr y to
E M U.

2-year maturity
5-year maturity

0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

C h a r t 6 E v o l u t i o n o f b e t a c o e f f i c i e n t s

(10-year government bond yields; 18-month rolling
regression)

Source: ECB.
Note: Based on a model reg ressing national 10-year
gover nment bond yields on benchmark German 10-year
gover nment bond yields.

-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Austria
Belgium
Finland
France
Greece

Ireland
Italy
the Netherlands
Portugal
Spain

0.85
0.90
0.95
1.00
1.05
1.10
1.15
0.85
0.90
0.95
1.00
1.05
1.10
1.15
2002 2003 2004 2005

C h a r t 7 A v e r a g e d i s t a n c e o f i n t e r c e p t / b e t a
f r o m v a l u e s i m p l i e d b y c o m p l e t e
i n t e g r a t i o n
(10-year government bond yields; 18-month rolling
regression)

Source: ECB.
Note: See Char t 6.

0.00
0.02
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
0.0

0.2
0.4
0.6
0.8
1.0
1.2

dispersion in intercepts (left-hand scale)
dispersion in betas (right-hand scale)

0.002

0.004

0.006

0.008

0.010

0.012

0.014

2002 2003 2004 2005
0.04
0.05
0.05
0.06
0.06
0.07
0.07
0.08
0.08

17
ECB c

Indicators of financial integration in the euro area
September 2005

C h a r t 8 V a r i a n c e r a t i o

(10-year government bond yields; 18-month rolling
regression)

Source: ECB.
Note: See Char t 6. Propor tion of the variance of national
10-year gover nment bond yields that is explained by the
variance in the benchmark Ger man 10-year gover nment
bond yield.

0
10
20
30
40
50
60
70
80
90

100

0
10
20
30
40
50
60
70
80
90
100

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
90

98
100
90
92
94
96
98
100
2002 2003 2004 2005
Austria
Belgium
Finland
France
Greece
Ireland
Italy
the Netherlands
Portugal
Spain

18
ECB c
Indicators of financial integration in the euro area
September 2005

C O R P O R A T E B O N D M A R K E T
C h a r t 9 P r o p o r t i o n o f c r o s s – s e c t i o n a l
v a r i a n c e e x p l a i n e d b y v a r i o u s f a c t o r s

(6-month averages; percentages)

explained by regression
explained by common, maturity, coupon, liquidity
and sector effects
explained by rating effect
explained by country effect
-5
0
5
10
15
20
25
30
35
40
-5
0
5
10
15
20
25
30
35
40
1998 1999 2000 2001 2002 2003 2004

C h a r t 1 0 E s t i m a t e d c o e f f i c i e n t s o f c o u n t r y
d u m m i e s

(6-month averages)

Sources: Bloomberg and ECB calculations.

Austria
Germany
Spain
France
Ireland
the Netherlands
Italy

-20

-15

-10

-5
0
5
10
15
20
-20
-15
-10
-5
0
5
10
15
20
1998 1999 2000 2001 2002 2003 2004

C h a r t 1 1 C r o s s – s e c t i o n a l d i s p e r s i o n o f
c o u n t r y p a r a m e t e r s

(basis points)

Sources: Bloomberg and ECB calculations.
0
2
4
6
8
10
12
14

16 16

0
2
4
6
8
10
12
14
1998 1999 2000 2001 2002 2003 2004 2005
Sources: Bloomberg and ECB calculations.

19
ECB c

Indicators of financial integration in the euro area
September 2005

E Q U I T Y M A R K E T
C h a r t 1 2 F i l t e r e d c o u n t r y a n d s e c t o r
d i s p e r s i o n s o f e u r o a r e a e q u i t y r e t u r n s

(percentages)

Source: Thomson Financial Datastream and ECB
c a l c u l a t i o n s .
Note: The char t shows Hodrick-Prescott f iltered cross-
sectional dispersions of monthly euro area countr y and
sector equity retur ns.

country dispersion
sector dispersion
1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
0
1
2
3
4
5
6
7
0
1
2
3
4
5
6
7

C h a r t 1 3 E u r o a r e a a n d U S s h o c k s p i l l o v e r
i n t e n s i t y

C h a r t 1 4 P r o p o r t i o n o f v a r i a n c e i n l o c a l
e q u i t y r e t u r n s e x p l a i n e d b y e u r o a r e a a n d
U S s h o c k s
(percentages)

1973-1985 1986-1991 1992-1998 1999-2005
0

5
10
15
20
25
30
35
40
0
5
10
15
20
25
30
35
40

20
ECB c
Indicators of financial integration in the euro area
September 2005

B A N K I N G M A R K E T
C h a r t 1 5 C r o s s – c o u n t r y s t a n d a r d d e v i a t i o n
o f M F I i n t e r e s t r a t e s o n l o a n s t o n o n –
f i n a n c i a l c o r p o r a t i o n s

Source: ECB.
Note: The measure is based on MFI interest rates on new
b u s i n e s s .

floating rate and up to 1 year initial rate fixation
over 1 year initial rate fixation

0.0
0.2
0.4
0.6
0.8
1.0
1.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
Jan. Mar. May July Sep. Nov. Jan. Mar. May Jan. Mar. MayJuly Sep. Nov.
2003 2004 2005

C h a r t 1 6 C r o s s – c o u n t r y s t a n d a r d d e v i a t i o n
o f M F I i n t e r e s t r a t e s o n l o a n s t o h o u s e h o l d s
a n d d e p o s i t s w i t h a g r e e d m a t u r i t y

Source: ECB.
Note: The measure is based on MFI interest rates on new
b usiness. Deposits with ag reed maturity include deposits
from non-f inancial cor porations and households.

consumer credit
lending for house purchase
deposits with agreed maturity
0.0
0.2
0.4
0.6
0.8
1.0
1.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
Jan. Mar. May July Sep. Nov. Jan. Mar. May Jan. Mar. MayJuly Sep. Nov.
2003 2004 2005

Chart 17 MFI loans to non-MFIs: outstanding amounts
by residency of the counterparty as a share of total
loans granted by MFIs, excluding the Eurosystem
(percentages)

Source: ECB.
Note: This indicator displays the geog raphical
counter par ty diversif ication of loans g ranted by euro area
MFIs to non-MFI counter par ties in other euro area
countries and non-euro area EU Member States.

other euro area countries
rest of EU
Sep.
1997
Mar.
2005
Mar. Sep.
1998
Mar. Sep.
1999
Mar. Sep.
2000
Mar. Sep.
2001
Mar. Sep.
2002
Mar. Sep.
2003
Mar. Sep.
2004
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0

Chart 18 MFI loans to MFIs: outstanding amounts by
residency of the counterparty as a share of total
loans granted by MFIs, excluding the Eurosystem
(percentages)

Source: ECB.
Note: This indicator displays the geog raphical
counter par ty diversif ication of loans g ranted by euro area
MFIs to MFI counter par ts resident in other euro area
countries and non-euro area EU Member States.

other euro area countries
rest of EU
Sep.
1997
Mar.
2005
Mar. Sep.
1998
Mar. Sep.
1999
Mar. Sep.
2000
Mar. Sep.
2001
Mar. Sep.
2002
Mar. Sep.
2003
Mar. Sep.
2004
0
5
10
15
20
25
0
5
10
15
20
25

21
ECB c

Indicators of financial integration in the euro area
September 2005
Source: ECB.
Note: The indicator shows securities held by euro area
MFIs and issued by non-MFIs resident in other euro area
countries and non-euro area EU Member States.
other euro area countries
rest of EU
Sep.
1997
Mar.
2005
Mar. Sep.
1998
Mar. Sep.
1999
Mar. Sep.
2000
Mar. Sep.
2001
Mar. Sep.
2002
Mar. Sep.
2003
Mar. Sep.
2004
0
5
10
15
20
25
30
35
40
0
5
10
15
20
25
30
35
40

Chart 19 MFI holdings of securities issued by non-MFIs:
outstanding amounts by residency of the issuer as a
share of total holdings, excluding the Eurosystem
(percentages)

Chart 2 0 MFI holdings of securities issued by MFIs:
outstanding amounts by residency of the issuer as a
share of total holdings, excluding the Eurosystem
(percentages)

Source: ECB.
Note: The indicator shows securities held by euro area
MFIs and issued by MFIs resident in other euro area
countries and non-euro area EU Member States. .

other euro area countries
rest of EU
Sep.
1997
Mar.
2005
Mar. Sep.
1998
Mar. Sep.
1999
Mar. Sep.
2000
Mar. Sep.
2001
Mar. Sep.
2002
Mar. Sep.
2003
Mar. Sep.
2004
0
5
10
15
20
25
30
0
5
10
15
20
25
30

22
ECB c
Indicators of financial integration in the euro area
September 2005

23
ECB c

Indicators of financial integration in the euro area
September 2005

MONEY MARKET INDICATORS (INDICATORS 1-3)

COMPILATION
The ECB avails itself of business frequency
(daily) data at the level of individual
institutions for both unsecured and secured
interbank short-term debt or deposits. The data
are made available by the European Banking
Federation (EBF) and cover the EONIA and
EURIBOR (unsecured lending) as well as the
EUREPO2 for different maturities.

For each dataset, the indicator is the
unweighted standard deviation (D

t
) of the

average daily interest rates prevailing in each
euro area country. The number of euro area
countries (n in the formula below) reflects the
number of countries having adopted the euro in
the reference period:

∑ −

ttct rrn
D 2, )(

1
(1)

where

r
c,t

is the unweighted average of the
interest rate r

i,t
reported by each of the m

c
panel

banks at time t in a given country c:

∑=
i

c
tc rm

r ,,
1

(2)

The euro area average r
t
is calculated as the

unweighted average of the average interest
rates r

c,t

The data are smoothed by calculating a
60-(business) day centred moving average of
the standard deviation, transformed into
monthly figures taking the end-of-month
observation of the smoothed series.

ADDITIONAL INFORMATION
The individual rates of the banks of the EONIA
panel are collected by the ECB on behalf of the
European Banking Federation. Every day on
which TARGET (the Trans-European
Automated Real-Time Gross Settlement
Express Transfer system) is open, each EONIA
panel bank reports to the ECB its aggregate
volume of intra-day unsecured lending
transactions and the weighted average lending
rate for these transactions. All lending

A N N E X 2 M E T H O D O L O G I C A L N O T E S 1

transactions carried out before the closing of
TARGET at 6.00 p.m. (C.E.T.) have to be
reported. The panel of reporting banks includes
only the most active banks located in the euro
area and beyond. Reported bid rates are
considered to be national rates of country X, if
the reporting bank has its headquarters in
country X. However, the counterparty of the
transaction is not known and the reported
interest rate could actually (in part) refer to
transactions with a bank outside country X.

EURIBOR and EUREPO rates do not relate to
transactions conducted during the day but are
indicative rates quoted by banks which are
members of the respective panels. Every panel
bank delivers its quotations for these
instruments directly to Moneyline Telerate no
later than 10.45 a.m. (C.E.T.) on each day that
TARGET is open. Moneyline Telerate no
responsible for computing the aggregate
EURIBOR and EUREPO indices and for
providing the underlying data to the EBF. Data
for EUREPO rates start in March 2002 when
the EUREPO index was introduced.

1 For additional technical background, see L.Baele, A. Ferrando,
P. Hördahl, E. Krylova and C. Monnet (2004), “Measuring
f inancial integration in the euro area”, ECB Occasional Paper
No. 14.

2 EONIA stands for euro overnight index average. It is the
effective overnight reference rate for the euro and is computed
as a weighted average of all overnight unsecured lending
transactions undertaken in the interbank market, initiated
within the euro area by the contributing banks. The EONIA is
computed with the help of the European Central Bank. The
banks contributing to the EONIA are the same as the
EURIBOR panel banks (composed of banks resident in the
euro area and in other EU Member States as well as some
international banks). The EURIBOR (euro interbank offered
rate) is the benchmark rate of the large euro money market that
has emerged since 1999. The EUREPO is the benchmark rate of
the euro repo market that has emerged subsequent to the
introduction of the euro in 1999. It is the rate at which
one prime bank offers funds in euro to another prime bank
when the funds are secured by a repo transaction using
general collateral. For further information, see http://
www.euribor.org/default.htm and http://www.eurepo.org/.

24
ECB c
Indicators of financial integration in the euro area
September 2005

GOVERNMENT BOND MARKET INDICATORS
(INDIC ATORS 4-8)

Standard deviations of government bond yield
spreads (indicators 4-5)

COMPILATION
The cross-country standard deviations of
government bond yield spreads for 2-, 5- and
10-year maturities are calculated on the basis
of daily data for the government bond yield
spreads relative to the government bond yield
in the country selected as a benchmark for the
calculation (Germany for the 10-year
maturities and France for 2- and 5-year
maturities). The standard deviation (S

t
) takes

the following form:

∑ −=
c

tbtct yyn
S 2,, )(

1
(3)

where y
c,t

denotes the yield on the government
bond of euro area country c with the relevant
maturity on day t and y

b,t
is the yield on the

government bond of the country selected as a
benchmark for that maturity (i.e. Germany or
France).

In the second step, data are smoothed by
calculating a 60-(business) day centred moving
average of the standard deviation, transformed
into monthly figures taking the end-of-month
observation of the smoothed series.

The standard deviation of 10-year government
bond yield spreads is based on bonds from
Belgium, Greece, Spain, France, Ireland, Italy,
the Netherlands, Austria, Portugal and Finland.
For the 5-year maturity, the government bonds
of Belgium, Germany, Greece, Spain, Ireland,
Italy, the Netherlands, Austria, Portugal and
Finland are used. For the 2-year maturity, the
measure is based on bonds from Belgium,
Germany, Greece, Spain, Italy, the
Netherlands, Austria, Portugal and Finland.
Greece enters the standard deviation
calculations for all maturities at the date of its
entry to EMU. For Luxembourg no benchmark
bond for the residual maturity of close to two,
five or ten years exists.

ADDITIONAL INFORMATION
Not all government debt in the euro area is fully
substitutable as regards, e.g. perceived credit
risk or liquidity of the relevant bonds. This
might affect the yields on the selected bonds
and thus the computed indicator.

Evolution of beta coefficients (indicator 6)

COMPILATION
If bond markets are fully integrated and
country-specific changes in perceived credit
risks do not occur, bond yields should only
react to news common to all markets. That is,
changes in the bond yields of individual
countries should react exclusively to common
news, which is reflected in a change of the
benchmark government bond yield. To separate
common from local influences, the following
regression is run:

tctgertctctc RR ,,,,, εβα +∆+=∆ (4)

where a denotes a country- and time-varying
intercept; b is a country- and time-dependent
beta with respect to the benchmark (German)
bond yield; DR is the change in the bond yield
and e is a country-specific shock.

The conditional betas are derived by estimating
the above regression using the first 18 months
of monthly averages. Subsequently, the data
window is moved one month ahead and the
equation is re-estimated, until the last
observation is reached. A time series for b

c,t
is

thus obtained.

ADDITIONAL INFORMATION
The outcome of the econometric specification
depends on the selection of the most
appropriate benchmark bond, in this case the
10-year German government bond. In addition,
one should not expect that common factors
fully explain changes in local bond yields as
“local news” concerning credit and liquidity
risks will continue to have an impact on local
yields.

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Indicators of financial integration in the euro area
September 2005

Average distance of intercept/beta from values
implied by complete integration (indicator 7)

COMPILATION
This indicator is derived using regression (4),
as for the previous indicator. From the
individual country regressions, the unweighted
average a

c,t
and b

c,t
values are calculated and

measured in proportion to the values implied
by complete market integration (0 and 1,
respectively). The analysis is based on monthly
averages of government bond yields.

ADDITIONAL INFORMATION
Same as for indicator 9.

Variance ratio (indicator 8)

COMPILATION
This indicator measures the proportion of the
variance in local (country-specific) yields that
is explained by the variance in the benchmark
(German) 10-year government bond yield; i.e.
the “variance ratio”. The indicator is derived
from the same 18-month rolling regression as
for the previous two indicators (see equation
(4) above). The total variance in local yields is
given by

( ) ( ) ( )tctbtctc VarRVarRVar ,,2,, εβ +∆=∆ (5)

and the variance ratio by:

( )
( )tc

tbtc
tc RVar

RVar
VR

2
,

, ∆
∆

=
β

(6)

Hence, a variance ratio close to one is obtained
when the beta approaches one and when the
volatilities of the local and the benchmark bond
yield changes are of a similar magnitude. The
analysis is based on monthly averages of
government bond yields.

ADDITIONAL INFORMATION
Same as for indicators 9 and 10.

CORPORATE BOND MARKET (INDIC ATORS 9-11)

Proportion of cross-sectional variance explained by
various factors (indicator 9)

COMPILATION
This indicator is derived by estimating the
following equation using an Ordinary Least
Squares (OLS) technique:

( ) r ti
K

r
trtt

i
rc CRztSP ,

1
,, ,, ∑

++= γατ

ti
N

c
tcitc

i
tt

s
ti

s
ts eCzS ,

1
,,,,

1
, ∑∑

+++ βϕδ (7)

where ( )ti rc ztSP ,,, τ is the yield spread
for corporate bond i at time t issued in country c
with τ years to maturity, with credit rating r and
set of instruments z

t
. a is an intercept common

to all corporate bonds, CRr
i,t

is a rating dummy
which takes a value of one when corporate bond
i belongs to rating category r at time t and zero
otherwise, and Ss

i,t
is a sector dummy which

takes a value of one for financial corporations
and zero for non-financial corporations. The
parameter vector u groups the sensitivities of
the various corporate bonds to the instruments
contained in zi

t
, namely time-to-maturity,

liquidity and coupon of the ith bond. As a proxy
of liquidity, we use the ratio of the number of
days that the bond has been traded to the total
number of trading days within every time
interval. tciC ,, is a country dummy that equals
one when corporate bond i belongs to country c
at time t, and zero otherwise.

The sample is composed of 1,990 individual
bonds that are used in the Merrill Lynch EMU
corporate bond index, which incorporates euro-
denominated investment-grade bonds with a
minimum size of issue of €100 million. Bonds
rated below investment grade and asset-backed
bonds are excluded from the analysis. In
addition, bonds with less than one year to
maturity and bonds which were traded less than
once per week in a given four-week time interval
were excluded. All euro-denominated bonds not
issued in a euro area country were eliminated as
well as data for countries that do not have at least

26
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Indicators of financial integration in the euro area
September 2005

ten corporate bonds in every time interval. Thus,
the analysis is based on a sample of bonds issued
in seven countries: Austria, France, Germany,
Ireland, Italy, the Netherlands and Spain. Italy
has been included in the regression analysis
from June 2003.

The indicator represents the proportion of
cross-sectional variance explained by the
various components (common, rating, sector,
maturity, liquidity coupon and country effects)
over time.

Estimated coefficients of country dummies over
time (indicator 10)

COMPILATION
As a test for integration, we test whether the
country parameters b

c,t
in equation (7) are zero,

or at least converge towards zero.

Cross-sectional dispersion of country parameters
(indicator 11)

COMPILATION
This indicator is derived by calculating the
average size of the estimated country dummies
derived from regression (7). An overall
decrease in the dispersion of the country effects
would be an indication of increasing
integration of the corporate bond market.

ADDITIONAL INFORMATION
Before June 2003 the indicators were
calculated without Italy.

EQUITY MARKET INDICATORS
(INDIC ATORS 12-14)

Filtered country and sector dispersions of euro area
equity returns (indicator 12)

COMPILATION
This indicator is derived by calculating the
cross-sectional dispersion of both sector and
country index returns for the euro area
countries.3 Data refer to the EMU global sector
indices provided by Datastream and are
calculated on a weekly basis from January 1973

onwards. They include (reinvested) dividends
and are denominated in euro.

The cross-sectional dispersions are filtered
using the Hodrick-Prescott smoothing
technique, which provides a smooth estimate of
the long-term trend component of the series.

ADDITIONAL NOTES
The indicator is useful for uncovering
structural changes in the aggregate euro area
equity market, but is less informative about
such changes in individual markets.

Euro area and US shock spillover intensity
(indicator 13)

COMPILATION
This measure is equivalent to the bond market
news-based indicators (e.g. indicator 9).
However, empirical evidence suggests that
equity returns are significantly driven by
global factors. For that reason, both euro area-
wide shocks and US shocks (as a proxy for
global factors) are included in the assessment
of common news.

To calculate the relative importance of euro
area-wide and US stock market fluctuations for
local stock market returns, the stock market
returns of individual countries are modelled as
having an expected component, and an
unexpected component, e

c,t
.4 The unexpected

component is then decomposed into a purely
local shock (e

c,t
) and a reaction to euro area

news (e
eu,t

) as well as world (US) news (e
us,t

tus
us

tcteu
eu
tctctc e ,,,,,, εβεβε ++= (8)

where b represents the country-dependent
sensitivity to euro area and US market changes

3 This indicator is based on an approach presented by
K. Adjaouté, and J.-P Danthine (2003), “European f inancial
integration and equity returns: a theor y-based assessment”, in
V. Gaspar, P. Hartmann and O. Sleijpen (eds. 2002).“The
transformation of the European financial system”.

4 The expected return is obtained relating euro area and US
returns to a constant term and to the returns in the previous
period. The conditional variance of the error terms is governed
by a bivariate asymmetric GARCH (1,1) model.

27
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Indicators of financial integration in the euro area
September 2005

(of the unexpected component of equity
returns), respectively.

In order to investigate the development of the
betas over time, three dummy variables are
introduced for the periods 1986-1992, 1992-
1998, and 1998-2005.

For each period, the indicators report the
unweighted average intensity with which euro
area-wide equity market shocks, other than
those from the United States, are transmitted
to local euro area equity markets and the
unweighted average intensity with which US
equity market shocks are transmitted to local
euro area equity markets.

Data refer to the EMU global sector indices and
are calculated on a weekly basis from January
1973 onwards.

ADDITIONAL INFORMATION
To be able to distinguish global shocks from
purely euro area shocks, it is assumed that euro
area equity market developments are partly
driven by events in the US market. It is
furthermore assumed that the proportion of
local returns not explained by common factors
is entirely due to local news.

Proportion of variance in local equity returns
explained by euro area and US shocks (indicator 14)

COMPILATION
To compare the relevance of euro area and US
shocks across average changes in country
returns, the indicators report the variance
ratios, i.e. the proportion of total domestic
equity volatility explained by euro area and US
shocks, respectively. The indicator is derived
by assuming that the total variance in
individual country-specific returns is given by

( ) ( ) 2 ,22 ,2,2, tusustteueuttctc h σβσβσ ++= (9)
where h

c,t
is the variance of the local shock

component. The euro area variance ratio is then
given by

( )
2
,

2
,
2

,
tc

teu
eu
teu

tcVR σ
σβ

= (10)

and correspondingly for the US. The
conditional variances are obtained from a
standard asymmetric GARCH (1,1) model.

For each period, the indicators report the
unweighted average of the relative importance
of euro area-wide factors, other than US equity
market shocks, for the variance in individual
euro-area countries’ equity market returns
(“variance ratio”), and the unweighted average
of the relative importance of US equity market
shocks for the variance in euro area equity
markets returns.

Data refer to the EMU global sector indices and
are calculated on a weekly basis from January
1973 onwards.

ADDITIONAL INFORMATION
The variance ratio is derived assuming that
local shocks are uncorrelated across countries
and that they are also not correlated with the
euro area and US benchmark indices.

BANKING MARKET INDICATORS
(INDICATORS 15-20)

Cross-country standard deviations of Monetary
Financial Institutions (MFI) interest rates
(indicators 15-16)

COMPILATION
The price measures for credit market
integration are based on MFI interest rates
(MIR) on new business reported to the ECB (in
accordance with the Regulation ECB/2001/18),
at a monthly frequency as from January 2003.

In detail, the following instrument categories
are considered:

– loans to non-financial corporations other
than bank overdrafts, with a floating rate and
up to one year of initial rate fixation;

28
ECB c
Indicators of financial integration in the euro area
September 2005

– medium- and long-term loans to non-
financial corporations, i.e. loans with over
one year of initial rate fixation;

– consumer loans to households;

– housing loans to households; and

– time deposits, i.e. deposits by households
and non-financial corporations with an
agreed maturity.

For the purpose of measuring financial
integration, it would be preferable to compute
the dispersion of rates as measured by the
standard deviation using unweighted interest
rates at the level of individual monetary
financial institutions. However, these data are
not available at the ECB and, therefore,
weighted rates and standard deviations are
calculated instead.

The following general notation is used for each
of the above categories of loans or deposits:

r
c,t

= the interest rate prevailing in country c in
month t,

b
c,t

= business volume in country c
corresponding to r

c,t .

tc
tc B

b
w ,, = is the weight of country c in the total

euro area business volume B: ∑
c

tcb ,

The euro area MFI interest rate is computed as
the weighted average of country interest rates
r

c,t
taking the country weights w

c,t

∑=
c

tr tc,tc, rw (11)

The euro area weighted standard deviation
takes the following form:

∑ −=
c

tcttc wrrM ,
2

, )( (12)

ADDITIONAL INFORMATION
Since the harmonised MFI interest rates have
only recently been established and a long time-

series is not yet available, the time horizon is
too short to make a meaningful analysis over
time (less than two and a half years of monthly
observations are available at present). This is
also the reason for not having smoothed the
data. Work is currently underway to estimate
historical data for MFI interest rates so as to be
able to show the evolution of financial
integration on the basis of these indicators over
a longer period.

Cross-border loans and securities holdings
(indicators 17-20)

COMPILATION
These indicators display the geographical
counterparty diversification of loans granted
by euro area MFIs (excluding central banks)
to non-MFI counterparties and other MFIs,
respectively, that is, within the same country
(domestic), other euro area countries, non euro
area EU Member States5 and the rest of the
world. Similar indicators are computed for
securities held by euro area MFIs and issued by
non-MFIs and MFIs, respectively.

ADDITIONAL INFORMATION
These four indicators are built on the basis of
the national aggregated MFI balance sheet data
reported to the ECB, at a monthly and quarterly
frequency (in accordance with Regulation
ECB/2001/13).6

These balance-sheet items are transmitted on a
non-consolidated basis. This means that the
transactions with foreign counterparties
include those with foreign-controlled branches
and subsidiaries.

5 Since May 2004, the group has comprised Denmark, Sweden,
the United Kingdom and the new EU Members States. Between
January 2001 and May 2004, Denmark, Sweden and the United
Kingdom formed this group while, before January 2001,
Greece was also included.

6 These data cover the MFI sector excluding the Eurosystem and
also include data on money market funds (MMFs). The
derivation of indicators strictly referring to banking markets is
not yet possible. Consequently, as MMFs typically invest in
inter-MFI deposits and short-term securities, three of the four
indicators considered are somewhat affected by the MMFs
balance sheet items. Only for the indicator showing loans to
non-MFIs, MFI and credit institutions data coincide.

=tB