Liquidity Pools, Risk Sharing, and Financial Contagion

This paper reevaluates the Allen–Gale (2000) analysis of interbank deposits to explain financial contagion. This paper modifies the pecking order of asset liquidation developed in Allen–Gale, which is essential in fragility analysis. Furthermore, we also provide a claim structure called liquidity pool that can both achieve risk sharing and prevent financial contagion across regions when asymmetric information about bank assets is absent. This model can partly explain why bank panics reduced substantially after the founding of the Fed and the role of IMF in regional financial crises.