Essays on Interbank Formation and the Implications of Financial Structure

As the events of the 2007 Crisis unfolded, it was clear that the failure or even rumors about the failure of one single institution could trigger freezes in numerous capital markets and widespread default in other financial institutions. How this was brought about, however, was everything but clear. Ten years later, as we stand today, the literature has progressed but many questions remain unresolved. The first question at hand is of course how banks were related and how these bilateral relationships were able to act as a passage of contagion. On the liability side, borrowing between banks provides liquidity insurance against their idiosyncratic shocks. In bad times however, insurance networks malfunctioned, and more centrally connected banks were able to monopolize on their market power to secure a larger surplus in the scramble for liquidity. My first paper further explores the relationship between network position and the ability to hoard liquidity. In addition, assets on bank balance comprise another important channel of contagion and one should ask to which extent cross holding of asset portfolios is optimal. When does the benefit from diversification over idiosyncratic risks dominate? And when does market risk increase systemic risk of common portfolio holdings? The second essay analyzes these questions from the perspectives of private and social welfare. In the end, one must also wonder how these networks were formed at the beginning and how the endogenous formation correlates with the structural implications. The third paper takes a step back and begins with a world where banks optimally choose links, prices and the amounts of trade. This endogenously determined network structure then serves as a coherent laboratory for understanding various frictions in the interbank market such as market freezes. Financial networks are complex and so is the research about them. Hence, in this thesis, I have attempted to shed light on them from various angles, utilizing both bilateral network data as well as theoretical analytical tools. It is my hope that taken together, this set of essays can contribute to a holistic understanding of interconnectedness in financial market.