Welfare effects of financial integration

Falko Fecht (), Hans Peter Grüner and Philipp Hartmann

No 2007,11, Discussion Paper Series 2: Banking and Financial Studies from Deutsche Bundesbank, Research Centre

Abstract: This paper compares four forms of inter-regional financial risk sharing: (i) segmentation, (ii) integration trough the secured interbank market, (iii) integration trough the unsecured interbank market, (iv) integration of retail markets. The secured interbank market is an optimal risk-sharing device when banks report liquidity needs truthfully. It allows diversification without the risk of cross-regional financial contagion. However, free-riding on the liquidity provision in this market restrains the achievable risk-sharing as the number of integrated regions increases. In too large an area this moral hazard problem becomes so severe that either unsecured interbank lending or, ultimately, the penetration of retail markets is preferable. Even though this deeper financial integration entails the risk of contagion it may be beneficial for large economic areas, because it can implement an efficient sharing of idiosyncratic regional shocks. Therefore, the enlargement of a monetary union, for example, extending the common interbank market might increase the benefits of also integrating retail banking markets through cross-border transactions or bank mergers.

Keywords: Financial integration; interbank market; cross border lending; financial contagion (search for similar items in EconPapers)
JEL-codes: D61 E44 G10 G21 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-mac
Date: Written 2007

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Related works:
Working Paper: Welfare Effects of Financial Integration (2007)
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