Financial Integration, Specialization, and Systemic Risk

Author(s): Falko Fecht, Hans Peter Grüner, Philipp Hartmann

CEPR Discussion Paper Number 8854
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Programme Area(s): Financial Economics (FE), International Macroeconomics (IM)

Date of Publication: 23/02/2012

Keyword(s): financial contagion, Financial integration, interbank market, risk sharing, specialization

JEL(s): D61, E44, G21

Abstract: This paper studies the implications of cross-border financial integration for financial stability when banks' loan portfolios adjust endogenously. Banks can be subject to sectoral and aggregate domestic shocks. After integration they can share these risks in a complete interbank market. When banks have a comparative advantage in providing credit to certain industries, financial integration may induce banks to specialize in lending. An enhanced concentration in lending does not necessarily increase risk, because a well-functioning interbank market allows to achieve the necessary diversification. This greater need for risk sharing, though, increases the risk of cross-border contagion and the likelihood of widespread banking crises. However, even though integration increases the risk of contagion it improves welfare if it permits banks to realize specialization benefits.

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