DP16880 A Theory of the Boundaries of Banks with Implications for Financial Integration and Regulation

Author(s): Falko Fecht, Roman Inderst, Sebastian Pfeil
Publication Date: January 2022
Keyword(s): Debt overhang, deposit insurance, integration, Interbank lending, risk shifting
JEL(s): F36, G21, L25
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16880

We offer a theory of the "boundary of the firm" tailored to banks as it builds on a single risk-shifting inefficiency and takes into account interbank lending, as an alternative to integration, and insured deposit financing. It explains why deeper economic integration should cause also greater, though still incomplete, financial integration, through both bank mergers and interbank lending, and why economic disintegration, as currently witnessed in the European Union, should cause less interbank exposure. Recent policy measures such as the preferential treatment of retail deposits, the extension of deposit insurance, or penalties on "connectedness" could reduce welfare.