Financial Integration And Liquidity Crises

This paper analyzes the effects of international financial integration on the stability of the banking system. Financial integration allows banks in different countries to smooth local liquidity shocks by borrowing on the international interbank market. The authors show that, under realistic conditions, financial integration induces banks to reduce their liquidity holdings and to shift their portfolios towards more profitable but less liquid investments. Integration helps to reallocate liquidity when different countries are hit by uncorrelated shocks.