Ebook Banks, Financial Markets and International Consumption Risk Sharing
How do countries deal with macroeconomic risk? In principle, countries should be able to pool and diversify idiosyncratic, that is, country-specific, risk internationally and thereby smooth consumption despite the occurrence of shocks. Although an extensive literature shows that the extent of consumption risk sharing between countries is relatively low (see e.g. Obstfeld and Rogoff, 2000; Lewis, 1999; Obstfeld, 1994; Backus et al., 1992), the precise channels through which risk is shared are less clear.
In this paper we study the role of domestic financial systems, by which we mean financial markets and banks, for the international sharing of consumption risk. The domestic financial system may be relevant for the international allocation of risk since it should provide instruments to share risk across countries. However, the provision of appropriate instruments may depend on how developed the financial system is and on how it is organized.
In general, countries with more developed financial systems are more likely to provide the appropriate instruments to share risk across borders. Thus, the overall development of the domestic financial system may determine the extent to which idiosyncratic risk can be diversified across countries. However, financial systems may be rather heterogeneous in terms of the development of the individual sectors. In other words, an overall highly developed financial system may be the result of a developed banking sector or sophisticated financial markets or both. If banks and financial markets are distinct channels for risk sharing then the degree of risk sharing achieved may in fact depend on the development of financial markets and of banks, respectively, and not on the overall development of the domestic financial system per se. In this case, it also follows that the extent of risk sharing may depend on which element of the financial system is dominant. In market-based systems, financial markets are relatively more important than the banking sector, whereas the opposite is true in countries which are better described as bank-based financial systems. Thus, risk sharing may vary across these types of financial system.
Against this background we explore empirically how characteristics of the domestic financial system influence the extent to which countries are able to share country-specific risk internationally. Our results indicate that it is primarily the development of financial markets which helps to share risk across countries. This result is in line with the idea that financial markets provide the necessary instruments to trade and diversify risk. Moreover, we find that banks play only a limited role for international risk sharing, which may be due to a home bias in bank assets (see e.g. Vazquez and Garcia-Herrero, 2007). Thus, financial markets and banks do not appear to be close substitutes for the international sharing of consumption risk. Furthermore, we find that countries characterized by market-based financial systems tend to be less exposed to idiosyncratic consumption risk than countries with bank-based systems.
Our analysis is closely related to Sorensen et al. (2007) and Hoffmann and Shcherbakova (2008) who argue that banks play an important role for the sharing of risk across US states. Thus, although the banking sector in the US contributes to risk sharing across states, banks do not appear to improve risk sharing across countries. The paper is also closely related to Hoffmann and Nitschka (2008). They show that the securitization of mortgage debt contributes significantly to risk sharing by making risk associated with residential real estate tradable. Yet, our analysis takes a broader view by analyzing the role of financial markets in general. Nevertheless, our results confirm that the tradability of risk helps to reduce the exposure to country specific shocks.
The paper is structured as follows: Section 2 sketches why characteristics of the domestic financial system may determine the degree of risk sharing and it summarizes the four issues that we explore in the paper. Section 3 describes the empirical methodology and the data set. Section 4 presents the estimation results. Section 5 summarizes and concludes the paper.
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