The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
This paper studies banks' decision to form financial interconnections using a model of financial contagion that explicitly takes into account the crisis state of the world. This allows us to model the network formation decision as optimising behaviour of competitive banks, where they balance the benefits of forming interbank linkages against the cost of contagion. We use this framework to study various market frictions that can result in excessive interconnectedness that was seen during the crisis. In this paper, we focus on two channels that arise from regulatory intervention-deposit insurance and the too big to fail problem.