joint work with Fabio Feriozzi and Guido Lorenzoni

This paper analyzes the effects of international financial integration on the stability of the banking system. Financial integration allows banks in di¤erent countries to smooth local liquidity shocks by borrowing on the international interbank market. We show that, under realistic 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 di¤erent countries are hit by uncorrelated shocks. However, when an aggregate, worldwide shock hits, the aggregate 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.
 

JEL Classification: F36, G21.
Keywords: Financial integration, systemic crises, interbank markets, skewness.

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