Multinational banks in regulated markets: is financial integration desirable?

A core question regarding the increasing share of international trade in financial services is whether this causes banks to take more or fewer risks. We study this issue in a setting where two multinational banks engage in duopoly competition for their lending in two regional markets. Each bank affiliate can choose both the lending volume and the level of monitoring, and hence risk-taking, where the risk of bank failure is partly borne by taxpayers in the bank affiliate's host country. Governments choose minimum capital requirements to optimally solve the trade-off between higher lending volumes and consumer surplus, and the expected tax losses faced by taxpayers. In this setting we consider two types of financial integration. A reduction in the transaction costs of cross-border banking increases risk-taking by banks, harming taxpayers and potentially overall welfare. In contrast, a reduction in the costs of screening foreign firms reduces banks' risk-taking and is beneficial for consumers and taxpayers alike.