Financial Liberalization and Contagion with Unobservable Savings

How does the presence of decentralized market-based channels for borrowing and lending affect financial integration and financial contagion? To answer this question, I develop a two-country model of financial intermediation, where banks have access to country-specific investment technologies, and agents can borrow and lend in an international hidden market. In this environment, the possibility of hidden borrowing and lending has three main effects. First, it improves welfare with respect to the autarkic equilibrium, by allowing gains from “hidden” financial integration. Second, it halts the process of “official” financial integration. Third, it lowers the resilience of the economy to unexpected shocks to fundamentals.