Financial integration

Financial integration is a phenomenon in which financial markets in neighboring, regional and/or global economies are closely linked together. Various forms of actual financial integration include: Information sharing among financial institutions; sharing of best practices among financial institutions; sharing of cutting edge technologies (through licensing) among financial institutions; firms borrow and raise funds directly in the international capital markets; investors directly invest in the international capital markets; newly engineered financial products are domestically innovated and originated then sold and bought in the international capital markets; rapid adaption/copycat of newly engineered financial products among financial institutions in different economies; cross-border capital flows; and foreign participation in the domestic financial markets.

Because of financial market imperfections, financial integration in neighboring, regional and/or global economies is therefore imperfect. For example, imperfect financial integration can stem from the inequality of the marginal rate of substitutions of different agents. In addition to financial market imperfections, legal restrictions can also hinder financial integration. Therefore, financial integration can also be achieved from the elimination of restrictions pertaining to cross-border financial operations to allow (a) financial institutions to operate freely, (b) permit businesses to directly raise funds or borrow and (c) equity and bond investors to invest across the state line with fewer [or without imposing any] restrictions. However, it is important to note that many of the legal restrictions exist because of the market imperfections that hinder financial integration. Legal restrictions are sometimes second-best devices for dealing with the market imperfections that limit financial integration. Consequently, removing the legal restrictions can make the world economy become worse off. In addition, financial integration of neighboring, regional and/or global economies can take place through a formal international treaty which the governing bodies of these economies agree to cooperate to address regional and/or global financial disturbances through regulatory and policy responses. The extent to which financial integration is measured includes gross capital flows, stocks of foreign assets and liabilities, degree of co-movement of stock returns, degree of dispersion of worldwide real interest rates, and financial openness.^[1][2] Also there are views that not gross capital flows (capital inflow plus capital outflow), but bilateral capital flows determine financial integration of a country, which disregards capital surplus and capital deficit amounts. For instance, a county with only capital inflow and no capital outflow will be considered not financially integrated.^[3]