shutterstock_93628438
Our paper considered the case where moral hazard can be controlled by costly risk monitoring undertaken by banks. While the details of the equilibrium in the credit market are model specific, the logic of the second best described in our paper should apply to other models as well – if the equilibrium is characterized by excessive risk, financial integration may magnify this distortion.

This paper provides another example of immiserizing growth, this time due to “excessive risk” induced by the combination of low banks’ cost of funds and costly financial integration. In these circumstances limited liability induces a distortion, leading frequently to overborrowing. |n autarky, the damaging effect of the distortion is confined by the limited availability of domestic savings, which act both to restrict investment and to reduce the size of the distortion. Financial integration would magnify the cost of the “excessive risk” distortion, both by increasing the distortion and by increasing the volume of investment.

The message of the model is that sequencing matters — efficient domestic banking is a pre condition for successful financial integration. Our paper suggests that financial integration and reforming the banking sector are complementary policies, as the gain of each reform is magnified by the second. If one starts with a highly inefficient banking system, reforming it and improving its operation is a precondition for successful financial integration.

Appendix A

The purpose of this Appendix is to characterize the equilibrium with partial defaults in the presence of macroeconomic risk (reviewed in section 4.1). We consider the simplest example, of two states of nature. Suppose that no producer would default in the good state of nature, as would be the case if (l + e)h(x)(.fi)0 > (l + ri)H (our discussion can be extended to cover the case where the weakest producers would default in all state of nature, without modifying the key results). Let us denote by x* the productivity index inducing marginal default in the bad state, defined by.
w6703-22