European Central Bank publishes research finding banking integration reallocates lending and reduces regional business cycle comovement

The European Central Bank has published a Working Paper under its Lamfalussy Fellowship Programme examining how banking networks transmit shocks across regions, concluding that geographically diversified banks can shift loan supply away from economies hit by negative idiosyncratic shocks and towards unaffected areas. In the authors’ framework, greater banking integration reduces output comovement across regions while making consumption patterns more synchronised. Using the staggered deregulation of interstate banking in the United States in the 1980s and 1990s as a natural experiment, combined with state-level idiosyncratic shocks constructed from labor productivity shocks to large firms, the paper estimates that a one standard deviation negative shock in one state increases economic growth in an integrated partner state by 0.05 to 0.19 percentage points. An instrumental-variable approach attributes the channel to lending reallocation, estimating that a 1% increase in bank loan supply raises economic growth by 0.06 to 0.25 percentage points. The analysis also reports that GDP growth correlations between states fall after integration while food consumption correlations rise, with stronger effects for geographically isolated and less persistent shocks and when banks face tighter capital constraints. The paper discusses implications for financial integration initiatives, including the European Banking Union and the European Capital Markets Union, suggesting that a stronger banking union could lead to divergence in member-state growth responses to idiosyncratic shocks, and proposes a banking-integration mechanism that can contribute to explaining the decline in aggregate volatility associated with the “Great Moderation”.