Financial integration, specializationand systemic risk

This paper studies the implications of cross-border financial integration for financialstability when banks’ loan portfolios adjust endogenously. Banks can be subjectto sectoral and aggregate domestic shocks. After integration they can share theserisks in a complete interbank market. When banks have a comparative advantagein providing credit to certain industries, they will exploit the enhanced risk sharingopportunities through more specialization in lending. The enhanced concentrationin lending does not increase risk, because a well-functioning interbank market allowsto achieve the necessary diversification. The greater need for risk sharing throughit increases, however, the risk of cross-border contagion. Better risk sharing andgreater risk of contagion tend to offset each other and financial integration improveswelfare since specialization benefits are realized.