The European Union (EU) enjoys deep financial integration, but researchers at NEOMA Business School warn offering abundant credit in these conditions risks creating stock market bubbles likely to burst and, due to market interdependence, trigger repeated crashes across the Eurozone.
This is because when credit is abundant, investment decisions drift away from economic fundamentals. Banks may become less vigilant, financing long-term, uncertain, and low-productivity projects, while companies prioritize stock buybacks over developing industrial capabilities.
A study co-authored by NEOMA professors Messaoud Chibane and Gabriel Giménez-Roche finds this phenomenon of “misinvestment” is a direct consequence of monetary policy.
“When interest rates are artificially kept at very low levels, the perception of risk becomes blurred. Economic agents then engage in strategies that inflate market valuations without creating solid value in return,” say the researchers.
When markets are financially integrated, negative impacts resulting from misinvestment are harder to contain.
The researchers analysed five leading Eurozone economies – Germany, France, Italy, Spain, and the Netherlands – between 2002-2022. Their findings reveal that as the probability of a crash increases, the stock markets of these countries become more synchronized, making geographic diversification less effective.
“A localized crash is no longer just an isolated incident: it can quickly spread to other markets, creating a chain reaction. Within an integrated monetary union, even a minor shock on a major stock exchange threatens the financial stability of the entire region,” say the researchers.
To prevent the situation from escalating, the researchers recommend implementing a tool to assess the probability of a crash in advance, allowing credit conditions to be temporarily tightened when risks rise. This preventive approach would help curb speculative bubbles before they burst.
“The idea is to act at the right moment. By slowing credit creation as soon as indicators turn orange, we can prevent the formation of overly fragile bubbles and protect markets from uncontrolled contagion,” say the researchers.
This study was published in The European Journal of Finance.
Featured Photo by ALEXANDRE LALLEMAND on Unsplash.