Financial integration and liquidity crises

Fabio Castiglionesi, F. Feriozzi, G. Lorenzoni

Research output: Contribution to journalArticleScientificpeer-review

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.
Original languageEnglish
Pages (from-to)955-977
JournalManagement science
Volume63
Issue number3
Early online dateOct 2017
DOIs
Publication statusPublished - Mar 2019

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Liquidity crisis
Financial integration
Liquidity
Interest rates
Banking system
Financial regulation
Liquidity shocks
Resources
Borrowing
Welfare benefits
Lending
Interbank market

Keywords

  • financial integration
  • liquidity crises
  • interbank markets
  • skewness

Cite this

Castiglionesi, Fabio ; Feriozzi, F. ; Lorenzoni, G. / Financial integration and liquidity crises. In: Management science. 2019 ; Vol. 63, No. 3. pp. 955-977.
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Financial integration and liquidity crises. / Castiglionesi, Fabio; Feriozzi, F.; Lorenzoni, G.

In: Management science, Vol. 63, No. 3, 03.2019, p. 955-977.

Research output: Contribution to journalArticleScientificpeer-review

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AB - 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.

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