Crisis Resolution and Bank Liquidity
Review of Financial Studies, Forthcoming
66 Pages Posted: 22 Jan 2010
Date Written: January 20, 2010
What is the effect of financial crises and their resolution on banks' choice of liquidity? When 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. The resulting choice of bank liquidity is counter-cyclical, inefficiently low during economic booms but excessively high during crises. We present evidence consistent with these predictions. While interventions to resolve banking crises may be desirable ex post, they affect bank liquidity in subtle ways: Liquidity support to failed banks or unconditional support to surviving banks reduces incentives to hold liquidity, whereas support to surviving banks conditional on their liquid asset holdings has the opposite effect.
Keywords: Cash, Cash holdings, Hoarding, Systemic risk, Fire sales
JEL Classification: G21, G28, G32, E58, D61
Suggested Citation: Suggested Citation