Financial frictions, financial integration and the international propagation of shocks

The recent Great Recession has been particularly remarkable not only for its unprecedented severity, but also for the exceptional degree of global interdependence in financial and real variables. A much-discussed channel of propagation hinges on the international exposure of the balance sheet of hig...

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Bibliographic Details
Published in:Economic policy 2012-04, Vol.27 (70), p.319-359
Main Authors: Dedola, Luca, Lombardo, Giovanni, Broner, Fernando
Format: Article
Language:English
Subjects:
Assets
Balance sheets
Banking industry
Capital investments
Cost
Credit
Economic conditions
Economic crisis
Economic interdependence
Economic policy
Finance
Financial contagion
Financial integration
Financial investments
Financial leverage
Financial risks
Gross domestic product
International finance
Investment returns
Investors
Net worth
Political integration
Recession
Return on capital
Risk management
Simulation
Studies
U.S.A
United States
Yield curves
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Summary:The recent Great Recession has been particularly remarkable not only for its unprecedented severity, but also for the exceptional degree of global interdependence in financial and real variables. A much-discussed channel of propagation hinges on the international exposure of the balance sheet of highly leveraged players to 'toxic' US assets. Yet, existing evidence on the role of exposure is mixed at best. This paper argues that under financial integration, the fact that leveraged investors face the same returns across internationally traded assets, would tend to equalize their borrowing cost across countries. Model simulations show that an unexpected increase in credit spreads in one country generates a similar increase in credit spreads in other financially integrated countries bringing about a global contraction, quite independently of the exposure to foreign assets in the balance sheet of leveraged investors. Our analysis thus suggests some caution in assessing the risks of 'contagion' on the exclusive basis of quantitative measures of integration based on cross-border balance sheet exposure.
ISSN:0266-4658
1468-0327
DOI:10.1111/j.1468-0327.2012.00286.x