Legal harmonization, institutional quality, and countries’ external positions: A sectoral analysis

Franziska Bremus,Tatsiana Kliatskova

doi:10.1016/j.jimonfin.2020.102217

Franziska Bremus, Tatsiana Kliatskova

Open Access

https://doi.org/10.1016/j.jimonfin.2020.102217

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Abstract

Motivated by the action plan for a European capital markets union (CMU), this paper analyzes the potential for legal harmonization and convergence in institutional quality to affect capital market integration. Based on hand-collected data on the implementation of EU-directives, our analysis yields three key insights. First, legal harmonization promotes portfolio equity holdings. Second, discrepancies in institutional quality matter primarily for cross-border debt positions. Third, the relationship between external investments and harmonization varies significantly across sectors: the non-bank financial corporations, which account for a large share of portfolio positions, react more to institutional harmonization than do banks and the non-financial private sector.

Highlights

Regulators and policy makers are facing the challenge to promote resilient capital market structures that support macroeconomic and financial stability
We focus on private investors and consider three different institutional sectors, namely banks, other financial corporations (OFC), and the non-financial private sector (NF) that includes non-financial corporations and households
In contrast to the existing studies, we provide a comprehensive overview over the determinants of investment behavior of sophisticated and less-sophisticated investors in both equity and debt markets, with a focus on differences in institutional quality and regulatory environment

Summary

Introduction

Regulators and policy makers are facing the challenge to promote resilient capital market structures that support macroeconomic and financial stability. The recent financial and sovereign debt crisis in Europe revealed a critical weakness: local stress was spreading across countries, such that the entire financial system became unstable. One reason for the system-wide stress is the financial market structure in Europe (Langfield and Pagano, 2016). Relative to GDP, the EU has a large, though shrinking banking sector, and rather underdeveloped bond and equity markets comparative to the other big economies (Figure 1). When the banking system ran into trouble, credit got scarcer in many countries, which impaired investment activity and, growth. Policy makers and academics increasingly stress the role of alternative, non-bank financing sources for European firms

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