Abstract
This paper analyzes links between institutional harmonization and bilateral portfolio debt and equity holdings at the sectoral level. Motivated by the action plan for the European Capital Markets Union, we examine the potential for legal harmonization and convergence in institutional quality to affect financial structures. Our analysis yields three key insights. First, legal harmonization across the EU promotes capital market integration via increased portfolio equity holdings. Second, discrepancies in institutional quality matter for cross-border portfolio positions: economic agents increase their portfolio debt investment in countries that are transparent and have efficient insolvency procedures, investor protection, and tax systems as compared to the domestic ones. Third, the relationship between external capital holdings and institutional harmonization varies significantly across sectors. The other financial corporations sector, which accounts for a large share of portfolio positions, tends to react more to institutional harmonization than do banks and the non-financial private sector.
Highlights
The financial and sovereign debt crisis in Europe revealed a critical weakness: local stress spread across countries, such that the entire financial system became unstable
We focus on private investors and consider three different institutional sectors, namely banks, other financial corporations (OFC), and the non-financial private sector (NF), which includes non-financial corporations and households
In contrast to existing studies, we provide a comprehensive overview of 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
The financial and sovereign debt crisis in Europe revealed a critical weakness: local stress spread across countries, such that the entire financial system became unstable. Relating to the debate about the CMU, we ask how harmonization of the regulatory environment affects countries’ external debt and equity positions, as well as whether cross-country differences in institutional efficiency matter for financial integration in Europe. While previous studies (Kalemli-Ozcan et al, 2010; Houston et al, 2012) look at the effect of regulatory harmonization on cross-border credit positions, our study provides evidence for portfolio debt and equity holdings, i.e. for capital market integration. In contrast to existing studies, we provide a comprehensive overview of the determinants of investment behavior of sophisticated (banks and other financial corporations) and less-sophisticated investors (households and non-financial corporations) in both equity and debt markets, with a focus on differences in institutional quality and regulatory environment.
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