Financial integration and liquidity crises

Fabio Castiglionesi*, Fabio Feriozzi, Guido Lorenzoni

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

10 Scopus citations

Abstract

This 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 toward 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 in which 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.

Original languageEnglish (US)
Pages (from-to)955-975
Number of pages21
JournalManagement Science
Volume65
Issue number3
DOIs
StatePublished - Mar 2019

Keywords

  • Financial integration
  • Interbank markets
  • Liquidity crises

ASJC Scopus subject areas

  • Strategy and Management
  • Management Science and Operations Research

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