Similar to the case of immiserizing growth, it is the interaction between the initial distortion (excessive risk) and globalization of financial markets that leads to these second best results.^ Even in these circumstances, the economy will benefit by financial integration that is accompanied by the proper improvements in the functioning of domestic banks. Furthermore, 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.

Section 2 outlines the model for the case where overborrowing is endogenously determined by banks facing idiosyncratic risk. Section 3 investigates the welfare effects of financial integration. Section 4 extends the model to account for macroeconomic shocks, and deposit insurance. Section 5 closes the paper with concluding remarks electronic-loan.com.

The model

All agents are risk neutral. Banks are competitive, and there is no reserve requirement. Each project costs H, and is characterized by a probability of failure \i, and by a productivity index x. The productivity index is unobserved by banks, but is known to entrepreneurs. Henceforth we refer to ц as measuring the project’s riskiness, and we assume that the entrepreneur determines it ex-ante. Projects are independent, and are ordered by declining productivity – a higher x is associated with a lower productivity. Failure implies zero income, whereas success implies income e = e(fi;x), where