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Financial Integration and Liquidity Crises

Author

Listed:
  • Fabio Castiglionesi

    (Department of Finance, CentER, and European Banking Center, Tilburg University, 5037 AB, Tilburg, Netherlands)

  • Fabio Feriozzi

    (IE Business School, IE University, 28006 Madrid, Spain)

  • Guido Lorenzoni

    (Department of Economics, Northwestern University, Evanston, Illinois 60208)

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.

Suggested Citation

  • Fabio Castiglionesi & Fabio Feriozzi & Guido Lorenzoni, 2019. "Financial Integration and Liquidity Crises," Management Science, INFORMS, vol. 65(3), pages 955-975, March.
    • Handle: RePEc:inm:ormnsc:v:65:y:2019:i:3:p:955-975
    DOI: 10.1287/mnsc.2017.2841
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    References listed on IDEAS

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    More about this item

    Keywords

    financial integration; liquidity crises; interbank markets;
    All these keywords.

    JEL classification:

    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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