The euro and a common monetary policy are key advantages for Europe. But they also heighten the danger of a wave of stock market crashes if the banks hand out too many loans when interest rates are low. These are the conclusions reached by three researchers, including NEOMA’s Messaoud Chibane and Gabriel Giménez-Roche.

The road to hell is paved with good intentions. When a Central Bank takes monetary policy actions – lowering interest rates, for instance – the aim is to jump-start growth, improve the solvency of banks and smooth out the stock markets. But this virtuous circle can go off the rails, setting off a chain reaction that may result in a financial “bubble” or even crash the markets.

And there’s worse: in countries where the economy and financial system are extensively intertwined, it can trigger an endless loop of stock market crashes.

Models for identifying the root causes of market crashes

This is the scenario that the researchers analysed over the period 2002 – 2022, zooming in on the five most buoyant economies in the euro zone: Germany, France, Italy, Spain and the Netherlands. They modelled two stock market crash processes to illustrate the critical factors behind the sudden drop in prices.

Their conclusions are intended for monetary authorities that are keen to optimise their interventions. The findings will also help major international investors make their investment choices: in the event of a chain reaction of collapses, even diversified portfolios are at risk of exposure.

In the first instance, the authors remind us that monetary policies have a tried-and-tested record of reversing adverse economic cycles. During the 2007 financial crisis and the Covid pandemic, the drop in interest rates and the injection of liquidity were instrumental in propping up the stock markets and banking system. This was corroborated by the two models designed for the study.

The context of “easy money” encourages “malinvestment”

But these operations modify key variables. Interest rate levels and capital on-hand no longer reflect the balance point between savings and investment. It is skewed by the decisions of the monetary authorities, which are designed to curb inflation, revive growth or sustain employment, for example.

For the banks and investors, on the other hand, interest rates and the availability of capital are still the benchmark criteria for lending or borrowing. If a Central Bank introduces a period of easy money, they will use credit more widely. This then stretches out the gap between currency issued and the total money supply, increasing the risk once more of a market crash.

Another phenomenon – “malinvestment” – adds fuel to the flames. With easy access to credit, the banks agree to finance more long-term projects with a heightened level of risk rather than shorter, safer projects. As for companies, they leverage buyback operations instead of developing their production capacity to unlock more profit. In more general terms, bank credit is guided to a lesser degree by the economic fundamentals: risk, duration and profitability… which then increases the long-term likelihood that the markets will crash.

Serial crashes highly likely in Europe

This risk is systemic in the European Union since capital circulates freely and financial regulations are by-and-large standardised between countries. As well as using the same currency, the most powerful EU nations – Germany, France, Italy, Spain and the Netherlands – are all subject to the policies of the European Central Bank. In addition, their national stock exchanges share the same information and synchronise the way they react to major national and international events, although the level of synchronization fluctuates over time.

The models developed by the researchers for 2002 – 2022 back up these observations. They show that the jump in the volume of bank loans and the increased use of credit by companies accentuate the risk of a crash. Similarly, the bigger the yield spread between the safest bonds (issued by governments) and the riskiest (issued by companies), the greater the danger is.

There is another phenomenon at work: as the likelihood of a crash grows, so the stock market movements of the five countries studied become more synchronised, both upwards and downwards. In other words: the risk level of an investor who has been careful to diversify their investments does not come down. This synchronisation is particularly apparent between the Frankfurt Stock Exchange and the exchanges in Paris and Amsterdam.

Tighter regulation of bank credit

Monetary policy measures, it follows, are double-edged swords. It’s true that they are instrumental in stabilising economies and financial markets when the economy takes a downturn. And yet, if the banks use this influx of liquidity to hike their lending activities, the risk of a stock market collapse grows and, in Europe, it can impact several states at the same time.

As a result, international investors should be wary of committing themselves to potentially-ineffective diversification strategies. As for the monetary authorities, they need to weigh up the consequences of their interventions with the utmost care. The authors suggest that they introduce a tool for assessing the likelihood of a crash. Above a pre-defined threshold, the credit offered by the banks would be heavily controlled or even governed by specific regulations.

Find out more

Chibane, A. Gabriel & G. A. Giménez Roche, The Impact of Bank Money on Stock Market Integration: Evidence from the Eurozone, The European Journal of Finance, May 2024 – doi.org/10.1080/1351847X.2024.2355104