I study multi-lateral incentive provision in the financial system. I develop a model of the financial system with liquidity shocks, moral hazard, and asymmetric information. Banks share liquidity by forming lending relationships with and without commitment. The decision to make lending relationships committed or uncommitted involves a tradeoff between liquidity provision and moral hazard. I highlight how uncommitted lending relationships, such as the credit lines between banks in the federal funds market, expose banks to potential liquidity shortages. However, liquidity shortages, which induce early default, can also align banks’ screening incentives. If banks collectively use uncommitted lending relationships, incentive alignment can be multi-lateral. Liquidity shortages can exacerbate or ameliorate contagion depending on information quality. These result from informed banks exerting externalities on uninformed banks. The model suggests the “tightness” of connections in the financial system should be an active consideration for policies targeting systemic risk-mitigation.
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