Curve CC traces the projects’ risk in the competitive equilibrium, and curve OO corresponds to the projects’ risk in the optimal allocation. As our previous discussion suggested, lower costs of financial intermediation increase the risk tolerated by banks. A combination of low banks’ cost of funds and a high supervision cost would lead to a large excessive risk. This situation is depicted by Figure 4, Panel I, where the excessive risk is about 10% for low interest rates. In these circumstances higher banks’ cost of funds increases welfare, as is depicted by the bold curve in Figure 3. A by product of the higher banks’ cost of funds is that the “excessive risk” distortion shrinks gradually, implying that for a high enough banks’ cost of funds the welfare effects of further increase in the banks’ cost of funds are reversed more.

Conversely, in a relatively efficient system the gap between the optimal and the actual riskiness is relatively small, as is depicted by panel II in Figure 4. In these circumstances financial integration is welfare enhancing, as is indicated by the top curve in Figure 3.

Extensions – Macro shocks, deposit insurance

The model outlined above should be viewed as a benchmark framework, and one can extend it to reflect other concerns. In this section we review the impact of macro shocks and deposit insurance. We show that higher macroeconomic volatility and a more generous deposit insurance magnify the “excessive risk” distortion. The presence of macro shocks and deposit insurance does not change the socially optimal risk, yet both would encourage banks to tolerate greater risk, increasing thereby the range where financial liberalization is welfare reducing.