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The euro area financial network and the need for better integration
At the time of the creation of the Economic and Monetary Union (EMU), it was widely held that balance of payments constraints for individual euro area countries would disappear. Contrary to this dominant view, private capital suddenly stopped flowing into euro area deficit countries in the wake of the financial crisis. Understanding why these financial constraints might emerge inside a monetary union is of crucial importance given its potential impact on resources allocation. We find that that the euro area financial system mirrors an arrangement of relatively closed networks connected mostly through banks and governments, two sectors that are strongly interconnected, over dependent on domestic economies and for which default is typically a complex way of satisfying their budget constraints. This fact is argued to lead to the amplification of shocks within each country. This has been observed in countries like Portugal during the recent european sovereign debt crisis. The article concludes that it is vital to mitigate the impact coming from the home bias in banks’ balance sheets, and consequent underdiversification, on the flow of funds between institutions with excess savings and non-financial sectors in any country. Cross-border expansion preferably following a branches model is one possibility. Nevertheless, mergers and acquisitions between banks from different euro area countries have not been very significant. In addition, the emergence of pan-european banks may increase the too-big-to-fail problem. This study suggests that asset-backed securities could be an efficient alternative to solve the problem.