Financial contagion

Financial contagion is modeled as an equilibrium phenomenon. Because liquid ity preference shocks are imperfectly correlated across regions, banks hold interregional claims on other banks to provide insurance against liquidity preference shocks. When there is no aggregate uncertainty, the first-best allocation of risk sharing can be achieved. However, this arrangement is fi nancially fragile. A small liquidity preference shock in one region can spr ead by contagion throughout the economy. The possibility of contagion depen ds strongly on the completeness of the structure of interregional claims. C omplete claims structures are shown to be more robust than incomplete struc tures.