Financial Imbalances and Financial Fragility

Abstract

Sudden reversals in banks' leverage cycle are modelled as the result of tensions between the abundance of liquidity and the limited capacity of the banking sector to process this liquidity and re-allocate it internally through the interbank market. I use the model to analyze the effects of financial integration of emerging market and developed economies. Financial integration permits a more efficient allocation of savings worldwide in normal times, but also entails capital flows toward developed economies. Financial crises occur when these capital inflows exceed the developed countries' absorptive capacity. Implications in terms of financial fragility, welfare, and policy interventions are discussed.

Keywords: Financial Integration, Global Imbalances, Asymmetric Information, Moral Hazard, Financial Crisis

JEL Classification: E21, F36, G01, G21