Liquidity Requirements, Free-Riding, and the Implications for Financial Stability Evidence from the early 1900s
Maintaining sufficient liquidity in the financial system is vital for its stability. However, since returns on liquid assets are typically low, individual financial institutions may seek to hold fewer such assets, especially if they believe they can rely on other institutions for liquidity support. We examine whether state banks in the early 1900s took advantage of relatively high cash balances maintained by national banks, due to reserve requirements, to hold less cash themselves. We find that state banks did hold less cash in places where both state legal requirements were lower and national banks were more prevalent.
We thank Ellis Tallman and David Wheelock for valuable comments. The views expressed in this paper are solely those of the authors and do not necessarily reflect those of the Board of Governors of the Federal Reserve or its staff. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.