Financial liberalization and contagion with unobservable savings

Abstract

How do market-based channels for the provision of liquidity affect financial liberalization and contagion? In order to answer this question, I extend the Diamond and Dybvig (1983) model of financial intermediation to a two-country environment with unobservable markets for borrowing and lending and comparative advantages in the investment technologies. I demonstrate that the role of hidden markets crucially depends on the level of financial integration of the economy. Despite always imposing a burden on intermediaries, unobservable markets allow agents to partially enjoy gains from financial integration when interbank markets are autarkic. In fully liberalized systems such effect instead disappears. Similarly, in autarky the distortion created by hidden markets improve the resilience of the system to unexpected liquidity shocks.With fully integrated interbank markets, such effect again disappears, as unexpected liquidity shocks always lead to bankruptcy and contagion.

Market participation in a two-sector Diamond-Dybvig economy

“…In that sense, the present work highlights that the mere coexistence of banks and markets does not justify, at least from a welfare perspective, the introduction of financial regulation, despite many other good reasons – that go beyond the scope of this paper – to do it. Interestingly, this conclusion complements a previous analysis that finds that, in environments with banks and markets, an unexpected shock to the fundamentals of one sector may not lead to bankruptcy or to financial contagion to the whole economy (Panetti, 2014). However, more work is needed to reconcile these findings with the observation that the reaction of the banking system to anticipated shocks to fundamentals is instead inefficient (Panetti, 2013).…”

“…The model builds on Panetti (2014). The economy lasts for three periods t = 0, 1, 2 and is divided into two sectors, labeled Home (H) and Foreign (F).…”