The dynamics of European financial market integration

We investigate financial market integration in Europe with a panel of 16 European and 4 non- European countries over the period 1970:01-2012:10. The theoretical framework considered is an international CAPM for equity excess returns with multiple common factors - a world factor and EU and euro country group factors - augmented with a local country-specific factor. While in the literature it is common practice to use observed variables and proxy’s for the factors, we estimate the ICAPM as a dynamic unobserved factor model with stochastic factor loadings and stochastic volatilities for the factor error terms. A measure for the time-varying degree of integration is calculated for each country with respect to the world and with respect to both country groups. The results suggest that, for all countries, integration has occurred mainly at the global level. The EU has been an additional driving force of financial market integration, especially for the initial EU member states in the 1970s. The contribution of the euro factor to financial market integration has been more important for the peripheral countries from the euro area than for the core economies. We also find that while the Great Recession (2008-2009) has temporarily increased the degree of financial market integration of European countries, no similar e ect can be observed with respect to the ensuing euro area debt crisis (2010-2012).