Financial Liberalization and Contagion with Unobservable Savings

Abstract

How does the presence of decentralized market-based liquidity channels affect financial liberalization and contagion? In order to answer this question, I extend the Diamond and Dybvig (1983) model of financial intermediation to a two-country environment, in which banks in each country enjoy a comparative advantage in one investment technology, and individuals can borrow and lend in an unobservable market. In this environment, I prove that the possibility of hidden savings has three main effects. First, it improves welfare with respect to the autarkic equilibrium by allowing gains from 'hidden' financial integration. Second, it halts the process of 'official' financial integration. Third, it lowers the resilience of the economy to unexpected liquidity shocks.

Keywords: financial intermediation, liberalization, financial contagion, unobservable savings

JEL Classification: E44, G21, G28