Working Paper: CEPR ID: DP5253
Authors: Falko Fecht; Hans Peter Grüner
Abstract: Recent empirical studies criticize the sluggish financial integration in the euro area and find that only interbank money markets are fully integrated so far. This paper studies the optimal regional and/or sectoral integration of financial systems given that integration is restricted to the interbank market. Based on Allen and Gale?s (2000) seminal analysis of financial contagion we derive the interbank market structure that maximizes consumers? ex ante expected utility, taking into account the trade-off between the contagion and the diversification effect of financial integration. We analyse the impact of various structural parameters including the underlying stochastic structure on this trade-off. In addition we derive the efficient design of the interbank market that allows for a cross-regional risk sharing between banks. We also provide a measure for the efficiency losses that result if financial integration is limited to an integration of the interbank market.
Keywords: Financial Contagion; Financial Integration; Interbank Market; Risk Sharing
JEL Codes: D61; E44; G10; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| integration of banks from economies with countervailing business cycles (F44) | diversification benefits (G11) |
| diversification benefits (G11) | overall risk profile of the interbank market (F65) |
| expected benefits from international diversification (G15) | expected costs from contagion (E44) |
| institutional arrangement of the interbank market (F33) | financial contagion (F65) |
| financial contagion (F65) | liquidity insurance among banks (G21) |
| integration of banks from economies with countervailing business cycles (F44) | overall risk profile of the interbank market (F65) |