Financial Institutions, Financial Contagion, and Financial Crises

Financial crises are endogenized through institutions related to the corporate sector and the interbank market. Financial crises can emanate from financial institutions which determines the nature of equilibrium in the interbank market. In a pooling equilibrium all illiquid banks are treated in the same manner in the interbank market. With private information about one's own solvency, best illiquid banks will not borrow but rather liquidate some premature assets. The withdrawal of the best banks from the interbank market will generate negative externalities in the interbank market. Consequently, the quality of the interbank market will decline - which will make more solvent but illiquid banks withdraw from the market -- and the quality of market deteriorates further. A cycle of this process leads to a collapse of the interbank market. However, in a separating equilibrium solvent and insolvent banks are distinguishable in the interbank market, bank runs are isolated to illiquid and insolvent banks, and a bank run contagion will never occur in such an economy.