Financial Liberalization with Hidden Trades

How does the availability of unregulated market-based channels for the circulation of liquidity in the financial system affect the process of financial integration? To answer this question, I develop a two-country model of banking, where the banks have access to country-specific investment technologies, and agents can borrow and lend liquidity in a hidden market. I characterize the competitive equilibria at different levels of integration (both in the banking system and in the hidden market) and show that the only level of integration which the two countries are able to coordinate is the one where the two banking systems are autarkic, but international hidden trades are possible. In contrast to the previous literature, I also find that the resulting consumption allocation is constrained efficient.