Essays on financial networks: Systemic risk and its regulation

The 2007-09 financial crisis exposed the vulnerabilities of the financial system. The events that characterized the crisis, such as the liquidation of the Reserve Primary Fund on account to its exposure to the failed investment bank Lehman Brothers, showed that distress can be propagated across different components of the financial system. To address the systemic risk associated with interconnectedness, a set of specific regulations were included in the broader framework that followed the crisis. In this dissertation, I analyze the design of interconnectedness-based regulation in the presence of market frictions and how the regulator can improve upon the trade-off between efficiency and financial stability implied by it by designing complementary regulatory instruments. In the first Chapter, I develop a microfounded design of interconnectedness-based regulation taking explicitly into account market imperfections, namely asymmetric information and limited commitment, and how the regulated institutions optimally respond to it. In my setting, banks establish connections to insure against idiosyncratic liquidity shocks. Even though this network of contractual obligations increases welfare via risk sharing, it can also propagate financial distress since some banks are also exposed to a solvency shock. However, when deciding their degree of interconnectedness, banks fail to internalize the distress costs imposed on the regulator, which motivates the introduction of financial regulation. I show that when the regulator is asymmetrically informed with respect to banks exposure to solvency shocks and is unable to commit to close troubled institutions, interconnectedness-based capital requirements imply a trade-off between efficiency and financial stability. In the second Chapter, I present a rollover game to study how interconnectedness-based regulation constrains the dynamic network formation process and based on this analysis I draw implications to the regulatory design. Finally, in the third Chapter, I analyze how the regulator can design complementary instruments to improve upon the trade-off that interconnectedness-based regulation implies and I compare the proposed instruments with the ones implemented in the post-crisis period.