Financial integration is widely perceived to stimulate investment-based growth through a reduction in the cost of equity, bond, and bank financing. Little is known, however, about the effect the integration of interbank markets has on small fi rm finance. How does the degree and speed of interbank market integration affect the availability and cost of bank loans? And does rapid integration simply lead to cheaper firm financing, or also to excessive leverage?
Given the freezing and subsequent partial disintegration of interbank markets after August 2007, and in order to make informed inferences about the effect of interbank market disfunctionality on the real economy, it is important to investigate how pre-crisis integration affected the financing of small and medium enterprises. By studying the mechanisms through which the integration of the interbank market works, our paper contributes to a growing literature on the bene fits and costs of financial globalization.
Theory suggests that interbank market integration increases the availability and reduces the cost of bank loans granted to fi rms through three di fferent channels. Interbank market integration: 1) increases the competition to supply bank loans; 2) reduces the cost of external funding for banks; and 3) allows for greater diversi cation of risk. As the interbank market provides banks with ready access to short and long-term loans to nance their own investment operations and cushion liquidity shocks, interbank market integration allows banks to o er more and/or cheaper financing.
The secured interbank market further allows for diversi cation without the risk of cross regional financial contagion (Fecht, Gruner, and Hartmann (2007)). Interbank market integration can therefore increase the bene ts of integrating the retail banking markets. The more favorable conditions at which banks will borrow and share risks in principle should result in better loan terms for all firms, and more nancing with bank loans.