Working Paper Series no. 149: Financial (Dis)Integration

Abstract

This paper addresses the macroeconomic impact of international financial integration. I first provide empirical evidence that foreign banking penetration can be associated with a contraction of banking credit, especially in countries with poor credit markets. Second I present a model in which the presence or the absence of foreign lenders endogenously modifies firms credit constraints and hence the volume of credit extended in the economy. Specifically, I show on the one hand that foreign lenders consider loans from domestic lenders as firm collateral. This implies that their lending supply is positively associated with the volume of capital a firm is able to borrow from domestic lenders (collateral effect). On the other hand, the presence of foreign lenders raises competition, reduces domestic lenders profits and hence reduces domestic lenders capital supply (competition effect). Two different cases are then possible. If foreign lenders are able, in spite of the collateral effect, to extend a large volume of loans even when domestic lenders lending capacity has shrinked (due to increased competition on the capital market), then the economy benefits at the steady state both from a large capital supply and a low cost of capital. Integration then raises the economy's growth rate. On the contrary, if foreign lenders are not able, due to the collateral effect, to extend a large volume of loans when domestic lenders lending capacity has shrinked, then competition reduces domestic lenders lending capacity and the collateral effect prompts foreign lenders to reduce their capital supply. Integration then depresses the economy's growth rate, firms cost of capital and the volume of credit extended in the economy.

Enisse Kharroubi
July 2006

Classification JEL : D82, E44, F36, G15, G21, O16.

Keywords : financial integration, borrowing constraint, informational collateral, competition, cost of capital.