We characterize the competitive equilibrium, where banks’ rents are dissipated, and the marginal project earns a zero rent. We show that a drop in banks’ cost of funds increases the risk tolerated by banks. Similarly, a less efficient intermediation technology (i.e., a more costly risk monitoring), higher macroeconomic volatility, and a more generous deposit insurance, all raise the equilibrium risk in a competitive equilibrium. Such an equilibrium tends to be inefficient — a combination of a low banks’ cost of funds and a high enough cost of financial intermediation would imply a large distortion due to excessive risk taking.

We construct the social welfare function, being the sum of the expected surplus of all domestic agents. We use this welfare function to evaluate the consequences of financial integration for an economy characterized by a relative scarcity of savings. For a large enough cost of financial intermediation, the dependence of welfare on banks’ cost of funds has an inverted U shape. A drop in the banks’ cost of funds due to financial liberalization would have two effects – the direct saving in financing costs of a given investment is welfare improving, whereas the increase in the “excessive risk” distortion is welfare reducing.

The “optimal depth” of financial liberalization is reached when these two effects balance at the margin. Any further welfare gain from financial liberalization would require improvement in the efficiency of financial intermediation. If the autarky banks’ cost of funds is relatively large, it will curb the excessive risk distortion in autarky, implying that partial financial liberalization would increase welfare. For such an economy, full financial integration would be welfare reducing relative to partial financial liberalization, as it leads to excessive risk undertaking. payday loans no credit check