1 Comments on ‘‘The Determinants of Cross-Border Lending in the Euro Zone” Evan Kraft

2 What the paper does  Studies financial integration in the Euro zone by looking at cross-border lending  Uses an enviable data set with bank-level data on cross- border loans  Applies the gravity model, a well-studied model with a long pedigree in the field of international trade  Takes seriously issues of culture and institutions as possible causes of frictions preventing cross-border lending and integration in general  Thorough and careful in variable definitions and econometric specifications, reasonable results

3 The microfoundations of the gravity model and the empirical literature  The model was proposed by Tinbergen (1962) and Pöyhönen (1963) in analogy with physics.  Andersen (1979) provided a microfoundation based on CES preferences  Anderson and van Wincoop (2003) point out the tendency of empirical papers to stray from the general equilibrium microfounded equations by adding ad-hoc variables. They demonstrate that a stricter interpretation of the model has very large empirical implications in studying trade between U.S. states and Canadian provinces.  Although challenging, it might be worthwhile to go back to theory here.

4 A question of symmetry  The model predicts two way flows, for example from Germany to Portugal and from Portugal to Germany.  Most variables in the model enter symmetrically, for example as a distance or a product of the same two variables.  The main variable that I could find that was not symmetrical was the REL variable.  In particular, many of the cultural variables use a Euclidian measure which is always symmetrical and positive  But it is not obvious that trust factors would be the symmetrical: if a high trust country is the supplier and the low trust country the demander, does the trust difference have the same effect as if the low trust country is the supplier and the high trust country the supplier? Is the elasticity of supply to trust differences the same as the elasticity of demand to trust differences?

5 A question of confidence  The cultural variables used here include trust, legal family, language, voice and some of the World Bank’s worldwide governance indicators (overall political risk, control of corruption, government effectiveness, political stability and absence of violence, regulatory quality, voice and accountability and rule of law)  However, a recent study by Ekinci, Kalemli-Ozcan and Sorensen (2007) finds that interregional capital flows in Europe are much more sensitive to confidence in institutions than trust.  Ekinci et al use data from the World Values Survey  The logic of their results is appealing: in financial markets, what counts is ability to enforce rules, especially contracts

6 A question of substitution  The model uses the proportion of the receiving country’s banking system held by foreign banks.  But it might make a difference which foreign banks. Returning to flows from Germany to Portugal, it would matter whether the foreign banks in Portugal were German or from other countries.  If there were German banks in Portugal, they would be choosing between lending directly from Germany and lending through their subsidiary in Portugal, and this might have different determinants than lending to a country where the bank had no presence “on the ground.”

7 A question of Croatia  Due to controls on lending, foreign borrowing by Croatian entities increased in 2003 and in  Fortunately for our authors, this is not a problem they have to model. Unfortunately for us at the Croatian National Bank, it is a problem we have to model. But that is another story….