This paper analyzes the e¤ects of …nancial integration on the banking system. Financial integration allows banks in di¤erent countries to smooth local liquidity shocks by borrowing on the international interbank market. We show that, under realistic conditions, …nancial integration induces banks to reduce their liquidity holdings and to shift their portfolios towards more pro…table but less liquid long-term investments. Integration helps to reallocate liquidity when di¤erent countries are hit by uncorrelated shocks. However, when an aggregate liquidity shock hits, the aggregate liquid resources in the banking system are lower than in autarky. Therefore, …nancial integration leads to larger spikes in interest rates on the interbank market in crisis episodes. For some parameter values, …nancial integration can lead to higher overall volatility of interbank rates. Furthermore, the distribution of consumption under integration can display both negative skewness and higher volatility than under autarky. The model is consistent with recent trends in external positions and liquidity holdings of banks in the US and in Europe. JEL Classi…cation: G21
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