A Note on Liquidity Policies and Financial Networks

Abstract

This note provides an example of how government and central bank policies that promote market liquidity (e.g., quantitative easing programs) can change the structure of the banking system, leading to financial networks that are better capitalized (networth of the banking system is higher) but, at the same time, more fragile (higher likelihood of bank failures). In the illustration provided, banks have to recur to the interbank market to raise funds necessary to invest in assets affected by liquidity policies, creating new channels for financial contagion in case the real sector is hit by negative shocks.

Keywords: Financial networks, market liquidity, financial fragility

JEL Classification: G21, G28