Welfare Effects of Financial Integration

38 Pages Posted: 23 May 2008

See all articles by Falko Fecht

Falko Fecht

Deutsche Bundesbank; Frankfurt School of Finance & Management

H. P. Gruner

University of Mannheim - Department of Economics; Institute for the Study of Labor (IZA); Centre for Economic Policy Research (CEPR)

Philipp Hartmann

European Central Bank (ECB); Centre for Economic Policy Research (CEPR) - International Macroeconomics

Multiple version iconThere are 2 versions of this paper

Date Written: May 2007

Abstract

This paper compares four forms of inter-regional financial risk sharing: (i) segmentation, (ii) integration trough the secured interbank market, (ii) integration trough the unsecured interbank market, (iv) integration of retail markets. The secured interbank market is an optimal risk-sharing device when banks report liquidity needs truthfully. It allows diversification without the risk of cross-regional financial contagion. However, free-riding on the liquidity provision in this market restrains the achievable risk-sharing as the number of integrated regions increases. In too large an area this moral hazard problem becomes so severe that either unsecured interbank lending or, ultimately, the penetration of retail markets is preferable. Even though this deeper financial integration entails the risk of contagion it may be beneficial for large economic areas, because it can implement an efficient sharing of idiosyncratic regional shocks. Therefore, the enlargement of a monetary union, for example, extending the common interbank market might increase the benefits of also integrating retail banking markets through cross-border transactions or bank mergers. We discuss these results in the context of the ongoing debate on European financial integration and the removal of bank branching restrictions in the United States during the 1990s, and we derive implications for the relationship between financial integration and financial stability. Last we illustrate the scope for cross-regional risk sharing with data on non-performing loans for the European Union, Switzerland and the United States.

Keywords: cross border lending, financial contagion, financial integration, interbank market

JEL Classification: F36

Suggested Citation

Fecht, Falko and Grüner, Hans Peter and Hartmann, Philipp, Welfare Effects of Financial Integration (May 2007). CEPR Discussion Paper No. DP6311, Available at SSRN: https://ssrn.com/abstract=1136618

Falko Fecht

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany
+4969956632312 (Phone)

HOME PAGE: http://https://www.bundesbank.de/en/falko-fecht

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Hans Peter Grüner

University of Mannheim - Department of Economics ( email )

D-68131 Mannheim
Germany

Institute for the Study of Labor (IZA)

P.O. Box 7240
Bonn, D-53072
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Philipp Hartmann (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
(49 69) 1344 7356 (Phone)
(49 69) 1344 8553 (Fax)

Centre for Economic Policy Research (CEPR) - International Macroeconomics

London
United Kingdom

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