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Financial Integration and Liquidity Crises

Fabio Castiglionesi (), Fabio Feriozzi () and Guido Lorenzoni

No 23359, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: F36 G15 G21 (search for similar items in EconPapers)
Date: 2017-04
New Economics Papers: this item is included in nep-cba
Note: IFM
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Published as Fabio Castiglionesi & Fabio Feriozzi & Guido Lorenzoni, 2019. "Financial Integration and Liquidity Crises," Management Science, vol 65(3), pages 955-975.

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