Banks Are Where The Liquidity Is
What is so special about banks that their demise often triggers government intervention? In this paper we develop a simple model where, even ignoring interconnectedness issues, the failure of a bank causes a larger welfare loss than the failure of other institutions. The reason is that agents in need of liquidity tend to concentrate their holdings in banks. Thus, a shock to banks disproportionately affects the agents who need liquidity the most, reducing aggregate demand and the level of economic activity. In the context of our model, the optimal fiscal response to such a shock is to help people, not banks, and the size of this response should be larger if a bank, rather than a similarly-sized nonfinancial firm, fails.
We would like to thank Arnoud Boot, Christian Leuz, Alp Simsek, Vania Stavrakeva, Robert Vishny, and participants in seminars at MIT, the University of Chicago, Cass Business School, LSE (finance), Boston College, and the University of Amsterdam for useful comments, and Kirill Borusyak for research assistance. Oliver Hart gratefully acknowledges financial support from the U.S. National Science Foundation through the National Bureau of Economic Research. Luigi Zingales gratefully acknowledges financial support from the Center for Research in Security Prices (CRSP) and the Initiative on Global Markets at the University of Chicago. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.