The recent financial crises in emerging market economies have focused attention on the role of financial intermediation in explaining the costs and benefits of capital market integration. Recent contributions stressed the tendency for overborrowing due to moral hazard considerations — a phenomena coined “the Overborrowing Syndromeā€¯ [see McKinnon and Pill (1996), Dooley (1997) and Krugman (196B)]. These studies identified the deposit insurance system as the key mechanism leading to overborrowing.

Yet, several observers questioned the importance of deposit insurance in explaining the crisis in the Far East. Thus, it remains a challenge to explain the dependence of overborrowing on the underlying economic structure — why does the Overborrowing Syndrome seem to matter for some countries, whereas other countries managed their borrowing more prudently. Source In order to address these issues, one should derive the Overborrowing Syndrome endogenously, in a more fully specified economic model.

The purpose of this paper is to construct such a model, and to argue that the welfare effects of financial integration are more involved than the ones suggested by the previous contributors. We show that the association between the depth of financial integration and welfare may be non-monotonic. We point out that overborrowing would arise even in the absence of deposit insurance in circumstances where the cost of financial intermediation is relatively high, the banks’ cost of funds is relatively low, and macroeconomic volatility is high.

Specifically, we propose a model where the riskiness of investment supported by banks is endogenously determined. Entrepreneurs rely on banks to finance investment, facing a trade off between risk and return. The limited liability associated with bank financing induces entrepreneurs to undertake excessive risk. We assume that banks may control this risk by costly monitoring, where greater risk reduction requires more resources devoted to project supervision.