Social and Behavioral Sciences Commons^™

This paper proposes an endogenous model of the formation of financial networks, where government and central bank policies that aim at enhancing market liquidity play a key role. Under these policies, large and less liquid investments become more profitable, but to finance them banks need to resort to the interbank market. This makes the structure of the financial network - and its associated exposure to shocks, i.e., fragility - to be dependent on liquidity policies chosen by the government and central bank. It is shown that, despite increasing the capitalization of the banking system, policies that enhance liquidity can make …