Note that the competitive equilibrium conditions (12) are a special case of (12′), for Q = l. Hence, the competitive equilibrium is associated with excessive risk if £2> 1. This is likely to hold the higher the supervision cost к is relative to the start up cost H(l + rc) 1

The welfare effects of financial integration are found by evaluating the implications of a drop in banks’ cost of funds. Applying (15) it follows that

In general, the effect of a drop in banks’ cost of funds is ambiguous, as the sign of — {\x-kz'(fi)]f(x)dx} may be positive. This term measures the net welfare effect of the increase in project’s risk induced by a lower bank’s cost of funds (recall that — <0). It equals — times the sum of the marginal effect of risk on project’s expected income, minus the marginal impact of higher risk on the monitoring cost, -fe'(Д). This sum is zero when the risk allocation is socially optimal, and is negative if excessive risk is undertaken, and positive if too little risk is undertaken add comment. Hence, —{f*[^^^-fc4A)]/(*)

There are 2 useful benchmark cases where the “excessive risk” distortion is absent, and thus (17) is unambiguously negative. First, if all projects are self financed, Q ancJ nQ resources are Spent on monitoring, thus -fe'(A) = 0. In these circumstances, (17) is negative, and a lower interest rate rc unambiguously raises welfare. Second, in the absence of “deep pockets,” if policies are used to induce the first best risk allocation, 0 = _ kz< (й)]/^)^ , and again (17) is negative.

The excessive risk distortion is eliminated in these benchmark cases, either due to the “full liability” associated with self financing, or due to the optimal design of policies. The dependence of welfare on the banks’ cost of funds may be nonmonotonic, characterized by an inverted U shape curve. This follows from Claim 3 — recall that a drop in the banks’ cost of funds and a less efficient intermediation technology increase the risk tolerated by banks. Hence, a combination of low banks’ cost of funds and a high enough cost of financial intermediation would increase the distortion associated with excessive risk taking, and may induce ^^>0. In these economies, a drop in the bank’s cost of

Refunds would lead to a ‘perverse’ outcome, reducing welfare. The reverse applies if the banks’ cost of funds increases. For a high enough banks’ cost of funds, the excessive risk distortion would be small enough so that the sign of (17) is reversed – further increase in the banks’ cost of funds reduces welfare [hence, (17) will become negative].