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... (forthcoming), on the other hand, shows that banks may choose not to buy default insurance on their counterparties, even though this may be socially desirable. This differs from our focus, which is to explicitly endogenize the network of interbank liabilities and study the implications of the financial network externality across institutions. Finally, our paper is related to the literature that emphasizes the possibility of indirect spillovers in the financial market. For example, Shleifer and Vishny (1992), Holmstrom and Tirole (1998), Brunnermeier and Pedersen (2005), Lorenzoni (2008) and Krishnamurthy (2010) study the potential impacts of firm-level distress on market distress or liquidity shortages. Rather than taking place through direct contractual relations as in our paper, the amplification mechanisms studied in these papers work through the endogenous responses of various market participants.10 The rest of the paper is organized as follows. Our model is presented in Section 2. Section 3 contains our results on the relationship between the extent of financial contagion and the financial network acrhitecture. In Section 4, we endogenize the interbank counterparty relations and study the finan...

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...even further. The idea that an increase in ambiguity aversion was central to the crisis has already been put forward (see, for example, Caballero and Krishnamurthy, 2008, Easley and O’Hara, 2010, and =-=Krishnamurthy, 2010-=-). My goal here is to emphasize that this idea has strong psychological foundations. Many economists are familiar with ambiguity aversion – the notion that people are averse to situations where they d...

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...nts and asset prices, which some authors argue played an important role in the 2008 financial crisis.1 Recent studies have emphasized the importance of financial shocks in generating fluctuations in macroeconomic aggregates.2 I borrow from these studies and introduce exogenous variations in collateral requirements, which I refer to as ‘credit shocks’. These variations are meant to capture the uncertainty in credit conditions faced by firms. Together with the borrowing constraint, these disturbances capture the fact that credit tightness fluctuates over 1See for instance Geanakoplos (2009) and Krishnamurthy (2010). 2Important examples are Jermann and Quadrini (2012) and Liu et al. (2013). 2 time. While those fluctuations may arise as optimal responses to other changes in the economy, modelling the endogenous determination of financial conditions is beyond the scope of this paper. The approach here is to to draw out the implications of the deteriorating credit conditions. The model presented in Section 2 has two types of agents. Households supply labor and funds. Capitalists do not supply labor but rather own the firms (and thus own the capital stock). In the model, firms can finance their operations th...