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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Journal of International Economics
Erasmus School of Economics

Fecht, F., Grüner, H. P., & Hartmann, P. (2012). Financial integration, specialization, and systemic risk. Journal of International Economics, 88(1), 150–161. doi:10.1016/j.jinteco.2012.01.012