Financial Integration and Liquidity Crises

Prior to the onset of the 2007/2008 financial crisis, Larry Summers remarked that "changes in the structure of financial markets have enhanced their ability to handle risk in normal times" but that "some of the same innovations that contribute to risk spreading in normal times can become sources of instability following shocks to the system." (Financial Times, December 26, 2006). Since the financial crisis, understanding what structural changes can open the door to financial instability has become of paramount relevance.

The paper “Financial Integration and Liquidity Crises” (Fabio Castiglionesi, Fabio Feriozzi, and Guido Lorenzoni, Management Science, 2019, Volume 65, No. 3) focuses on an important development of financial markets occurred in the years before the crisis, namely, the rapid integration of international interbank markets, as part of a more general phenomenon of globalization of the banking industry. The paper then studies the consequences of increasingly integrated banks on the stability of the banking system, and formalizes its contrasting effects in normal times and during crises.

A globalized banking industry allows banks located in different countries to smooth local liquidity shocks by borrowing and lending on the world interbank market. Everything else equal, this should have a stabilizing effect, thanks to the additional sources of short-term funds banks can rely on to cover a liquidity shortage. That is, financial integration should help dampen the effects of local liquidity shocks. However, the authors uncover an unintended consequence of a globalized banking industry. An easier access to liquid resources on the world interbank market changes the ex-ante incentives of banks when they make their lending and portfolio decisions. In particular, banks that can readily obtain short-term funds on the interbank market may choose to hold lower reserves of (safe) liquid assets and to increase the investment in less liquid and/or more risky assets.

Once this endogenous response is taken into account, the equilibrium effects of financial integration on financial stability are less clear. If a systemic event hits all banks, the lower holdings of liquid reserves in the banking industry can lead to a larger increase in interbank rates. Therefore, financial integration tends to make the distribution of interest rate more skewed, with low and stable interest rates in normal times, in which regional shocks offset each other, and occasional spikes when an economy-wide systemic shock hits. The authors show that if the probability of a systemic shock is large enough, the overall effect of interbank integration is to increase interest rate volatility. The paper also looks at the model’s implications for the distribution of consumption. Similarly to what happens to interest rates, in a globalized banking industry the distribution of consumption tends to become more skewed and can display higher volatility.

The authors conduct the analysis in the context of a model with minimal frictions, where banks allocate liquidity efficiently by offering state-contingent deposit contracts. In this setup, equilibria are Pareto efficient and the increased volatility that can follow financial integration is not a symptom of inefficiency. Although this result clearly follows from the absence of relevant frictions, it points to a more general observation: the negative effects of financial integration on volatility should not be taken as unequivocal evidence that integration is ex-ante undesirable.

Finally, the paper analyzes the implications of the previous mechanism for regulation. The authors   consider a variant of the model where banks borrow and lend from each other on a spot interbank market instead of writing state-contingent interbank deposits. In this case, banks typically hold an inefficient amount of liquid resources as they essentially free ride on each other's liquidity holdings. In this context, the authors show that financial integration can worsen the free-riding problem, thus making liquidity regulation in the spirit of Basel III desirable.

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Castiglionesi, F, Feriozzi F, and Lorenzoni G (2019). Financial Integration and Liquidity Crises. Management Science 65(3):955 - 975.