Financial Integration, Specialization, and Systemic Risk

Abstract

This paper studies the stability implications of the cross-border integration of interbank markets. Integration enhances the diversification options of banks across borders and improves the resilience of the banking sector to idiosyncratic shocks. At the same time integration also increases the risk of contagion across borders given aggregate asymmetric shocks: A default of one bank due to a severe regional shock is transmitted over an integrated interbank market to banks across borders and might ultimately destabilize banks that were initially not affect be the regional shock. When analyzing this trade-off this paper takes into account that improved diversification options of idiosyncratic risks affect banks investment decisions leading to more specialization in lending. Apparently, the greater the specialization the larger is the need for risk sharing and the more reliant are regional financial institutions on the integrated financial market. Thus due to financial integration the exposure to other regions rises and increases the systemic risk.

Keywords: Financial integration, interbank market, specialization, financial contagion

JEL Classification: D61, E44, G21