Financial integration, specialization, and systemic risk

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may AbstractThis paper studies the implications of cross-border financial integration for financial stability when banks' loan portfolios adjust endogenously. Banks can be subject to sectoral and aggregate domestic shocks. After integration they can share these risks in a complete interbank market. When banks have a comparative advantage in providing credit to certain industries, financial integration may induce banks to specialize in lending. An enhanced concentration in lending does not necessarily increase risk, because a well-functioning interbank market allows to achieve the necessary diversification. This greater need for risk sharing, though, increases the risk of cross-border contagion and the likelihood of widespread banking crises. However, even though integration increases the risk of contagion it improves welfare if it permits banks to realize specialization benefits.Keywords: Financial integration, specialization, interbank market, financial contagion JEL Classification: D61, E44, G21 1 Non technical summaryA key question for Europe and the world after several years of crisis is whether the process of financial integration should continue or whether slowing it down may bring advantages in terms of greater financial stability. One significant benefit of financial integration is that it generally improves risk sharing across borders. It reduces the impact of regional shocks on domestic consumption. Greater diversification through financial markets at the same time also allows realising specialisation benefits at the regional or firm level. When diversification of sectoral risks can be achieved through integrated financial markets, regions or firms can focus on those technologies in which they have a comparative advantage.Financial globalisation of the recent decades has been driven to a significant extent by a greater integration of interbank markets. But interbank integration not only provides greater scope for risk sharing. It also brings about the risk of cross-border financial contagion. If a regional shock exceeds the risk bearing capacities of a regional bank, it fails and cannot honour its commitments. This can lead to failures of banks abroad, which have lent money to it, are suspected by others to have done so (asymmetric information) or because of a general dry-up of liquidity. Thus from a welfare perspective financial integration is only beneficial if the expected benefits from greater risk-sharin...

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