Financial Integration and Systemic Risk

Abstract

Recent empirical studies criticize the sluggish financial integration in the euro area and find that only interbank money markets are fully integrated so far. This paper studies the optimal regional and/or sectoral integration of financial systems given that integration is restricted to the interbank market. Based on Allen and Gale's (2000) seminal analysis of financial contagion we derive the interbank market structure that maximizes consumers' ex ante expected utility, taking into account the trade-off between the contagion and the diversification effect of financial integration. We analyze the impact of various structural parameters including the underlying stochastic structure on this trade-off. In addition, we derive the efficient design of the interbank market that allows for a cross-regional risk sharing between banks. We also provide a measure for the efficiency losses that result if financial integration is limited to an integration of the interbank market.

Keywords: Interbank market, risk sharing, financial contagion, financial integration

JEL Classification: D61, E44, G10, G21