Crisis Resolution and Bank Liquidity
50 Pages Posted: 25 Mar 2008 Last revised: 11 Nov 2010
Date Written: March 18, 2008
What is the eﬀect of ﬁnancial crises and their resolution on banks’ choice of liquid asset holdings? When risky assets have limited pledgeability and banks have relative expertise in employing risky assets, the market for these assets clears only at ﬁre-sale prices following a large number of bank failures. The gains from acquiring assets at ﬁre-sale prices make it attractive for banks to hold liquid assets. We show that the resulting choice of bank liquidity is counter-cyclical, ineﬃciently low during economic booms but excessively high during crises, and present and discuss evidence consistent with these predictions. Since ineﬃcient users may enter asset markets when prices fall suﬃciently, interventions to resolve banking crises may be desirable ex post. However, policies aimed at resolving crises aﬀect ex-ante bank liquidity in subtle ways: while liquidity support to failed banks or unconditional support to surviving banks in acquiring failed banks give banks incentives to hold less liquidity, support to surviving banks that is conditional on their liquid asset holdings creates incentives for banks to hold more liquidity.
Keywords: Cash, Cash holdings, Crises, Systemic risk, Distress, Liquidation cost, Limited pledgeability
JEL Classification: G21, G28, G32, E58, D61
Suggested Citation: Suggested Citation