Financial integration and liquidity crises
Castiglionesi,Fabio Feriozzi,F. Lorenzoni,G.
Castiglionesi,Fabio
Feriozzi,F.
Lorenzoni,G.
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 common 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 to reallocate liquidity when different banks are hit by uncorrelated shocks. However, when a systemic (correlated) 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. Similarly, on the real side, financial integration leads to more stable consumption in normal times and to larger consumption drops 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.
Description
Date
2019-03
Journal Title
Journal ISSN
Volume Title
Publisher
Research Projects
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Journal Issue
Keywords
financial integration, liquidity crises, interbank markets, skewness, SDG 10 - Reduced Inequalities
Citation
Castiglionesi, F, Feriozzi, F & Lorenzoni, G 2019, 'Financial integration and liquidity crises', Management Science, vol. 65, no. 3, pp. 955-975. https://doi.org/10.1287/mnsc.2017.2841
License
info:eu-repo/semantics/closedAccess