Welfare Effects of Financial Integration

This paper compares four forms of inter-regional financial risk sharing: (i) segmentation, (ii) integration trough the secured interbank market, (iii) 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