Financial Integration at Times of Financial Instability

Abstract

1both individually and systematically. Integration can increase the investment opportunities of individual fi nancial institutions, allowing them to make higher returns at the same level of risk. On the other hand, if individual fi nancial institutions are exposed to the same risks 2 , the risks of their portfolios as a whole are not necessarily diversifi ed at all and the positive effect of market integration may thus be reduced. Moreover, the fi nancial sector as a whole may be more vulnerable to systemic risk and contagion risk in conditions of high geographical and sectoral integration of the banking and other fi nancial markets. Whether the benefi ts of deepening fi nancial integration outweigh the risks, and whether this process will lead to increasing fi nancial stability, depends largely on the resilience and fl exibility of the fi nancial system itself, which national and international authorities should be working to enhance. This article primarily analyses the fi nancial integration of the Czech fi nancial market (the money, foreign exchange, government bond and equity markets) with the fi nancial market of the euro area (or Germany for the government bond market) at times of fi nancial (in)stability. The article also includes analogous results for selected infl ationtargeting Central European economies (Hungary and Poland) and advanced Western economies (Sweden and the UK). The article is structured as follows. Section 2 looks at the defi nition of fi nancial integration and summarises the benefi ts and costs associated with this process and then examines the relationship between fi nancial integration and fi nancial (in)stability. Section 3 summarises the methods for measuring fi nancial integration and discusses in detail the results of an empirical analysis of the impact of fi nancial (in) stability on fi nancial integration. Section 4 concludes.