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.

Financial contagion, Financial integration, Interbank market, Specialization,
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