Capital Mobility In A Second–Best World: Moral Hazard With Costly Financial Intermediation

The paper studies financial integration in the presence of moral hazard, where banks may mitigate excessive risk by costly monitoring. The author shows that a drop in banks’ cost of funds, less efficient intermediation technology, higher macroeconomic volatility, and a more generous deposit insurance raise the riskiness of projects in a competitive equilibrium. Overborrowing would arise even in the absence of deposit insurance in circumstances where the cost of risk monitoring is high, the banks’ cost of funds is relatively low, and macroeconomic volatility is high. Reforming an inefficient banking system and improving its operation is a precondition for successful financial integration.