When is Less More? Bank Arrangements for Liquidity vs Central Bank Support
Theory suggests that in the face of fire-sale externalities, banks have incentives to overinvest in order to issue cheap money-like deposit liabilities. The existence of a private market for insurance such as contingent capital can eliminate the overinvestment incentives, leading to efficient outcomes. However, it does not eliminate fire sales. A central bank that can infuse liquidity cheaply may be motivated to intervene in the face of fire sales. If so, it can crowd out the private market and, if liquidity intervention is not priced at higher-than-breakeven rates, induce overinvestment once again. We examine various forms of public intervention to identify the least distortionary ones. Our analysis suggests why private contingent capital dominated in the era preceding central banks and deposit insurance, why it waned subsequently, as well as why banking crises and speculative excesses continue to recur periodically.
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Copy CitationViral V. Acharya, Raghuram Rajan, and Zhi Quan (Bill) Shu, "When is Less More? Bank Arrangements for Liquidity vs Central Bank Support," NBER Working Paper 34099 (2025), https://doi.org/10.3386/w34099.Download Citation
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