Working Paper: NBER ID: w23359
Authors: Fabio Castiglionesi; Fabio Feriozzi; Guido Lorenzoni
Abstract: The paper analyzes the effects of financial integration on the stability of the banking system. Financial integration allows banks in different regions to smooth local liquidity shocks by borrowing and lending on a world interbank market. We show under which conditions financial integration induces banks to reduce their liquidity holdings and to shift their portfolios towards more profitable but less liquid investments. Integration helps reallocate liquidity when different banks are hit by uncorrelated shocks. However, when a correlated (systemic) shock hits, the total liquid resources in the banking system are lower than in autarky. Therefore, financial integration leads to more stable interbank interest rates in normal times, but to larger interest rate spikes in crises. These results hold in a setup where financial integration is welfare improving from an ex ante point of view. We also look at the model's implications for financial regulation and show that, in a second-best world, financial integration can increase the welfare benefits of liquidity requirements.
Keywords: financial integration; liquidity crises; banking stability
JEL Codes: F36; G15; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial Integration (F30) | Reduced Liquidity Holdings (G19) |
| Financial Integration (F30) | Interest Rate Volatility (E43) |
| Reduced Liquidity Holdings (G19) | Increased Interest Rate Volatility (E43) |
| Financial Integration (F30) | Increased Consumption Volatility (D11) |