We show in this paper that bank failures can be contagious. Unlike earlier work where contagion stems from depositor panics or ex ante contractual links between banks, we argue bank failures can shrink the common pool of liquidity, creating or exacerbating aggregate liquidity shortages. This could lead to a contagion of failures and a possible total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact and can cause each other, making it hard to determine the root cause of a crisis from observable factors. We propose a robust sequence of intervention.
*Published:
Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, 04.
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