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Bank integration and systemic risk: Panacea or pandemic?

The increasing integration of banks in the Asia-Pacific region is often associated with the banking sector’s vunerability to adverse shocks and financial instability. As the main financial intermediaries in the region, banks play an important role in mediating the region’s vast savings and capital flows. In light of the increasing interconnectedness between banks and the rising threat of financial volatility, this study aims to determine whether bank integration mitigates cross-border systemic risk or acts as a conduit for systemic risk. The effect of the business cycle and the real interest rate in facilitating the spread of systemic risk is also examined. In addition, we investigate the long-term effect of bank integration on systemic risk resulting from habit-persistence in bank lending behaviour. The sample consists of 36 country-pairs and covers the period from Q4 1997 to Q1 2010. Using daily returns from the national banking sector stock indices, the cross-border systemic risk measure is computed as the conditional covariance from a bivariate GARCH constant conditional correlation model. Meanwhile bank integration is measured using confidential data from the Bank of International Settlements. Panel data regression methods are employed to examine the impact of bank integration, the business cycle and the real interest rate on cross-border systemic risk in the region. A panel 2-stage least squares instrumental variable estimation is then used to examine the long-term effect of bank integration on systemic risk. We present strong empirical evidence that intensified bank integration increases cross-border systemic risk between a country-pair. An adverse economic environment and high real interest rate in the reporting country tends to exacerbate cross-border systemic risk between a reporting and vis-à-vis country-pair. The study also finds that banks in vis-à-vis countries become more vulnerable to the macroeconomic environment of the reporting country as bank integration between the country-pair increases. Bank integration also has a longer-term effect on systemic risk. The results confirm our suspicion that habit-persistence in bank lending behaviour causes cross-border systemic risk to be accumulated over time and manifest only at a later period. The findings from this study alerts the region’s policy makers to the need to develop a sustainable framework for effective cross-border bank supervision and regulation. Further financial co-operation in the region needs to be discussed with regard to the provision and protection of lines of liquidity that bank integration offers from the risks that threaten it.