Financial Integration and Liquidity Crises

50 Pages Posted: 1 May 2017 Last revised: 30 Apr 2023

See all articles by Fabio Castiglionesi

Fabio Castiglionesi

Tilburg University - Department of Finance

Fabio Feriozzi

Jaume I University

Guido Lorenzoni

Northwestern University; National Bureau of Economic Research (NBER)

Date Written: April 2017

Abstract

The 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 towards 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 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.

Suggested Citation

Castiglionesi, Fabio and Feriozzi, Fabio and Lorenzoni, Guido, Financial Integration and Liquidity Crises (April 2017). NBER Working Paper No. w23359, Available at SSRN: https://ssrn.com/abstract=2961083

Fabio Castiglionesi (Contact Author)

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Fabio Feriozzi

Jaume I University ( email )

Castellon
Castellón de la Plana, Castellón de la Plana 12071
Spain

Guido Lorenzoni

Northwestern University ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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