When is Less More? Bank Arrangements for Liquidity vs Central Bank Support

Viral V. Acharya; Raghuram Rajan; Zhi Quan (Bill) Shu

doi:10.3386/w34099

When is Less More? Bank Arrangements for Liquidity vs Central Bank Support

Viral V. Acharya, Raghuram Rajan & Zhi Quan (Bill) Shu

Working Paper 34099

DOI 10.3386/w34099

Issue Date August 2025

Theory suggests that in the face of fire sale externalities, banks have incentives to overinvest in order to issue excessive 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. We examine various forms of public intervention to identify the least distortionary ones. Our analysis helps understand the historical prevalence of private insurance in the era preceding central banks and deposit insurance, their subsequent disappearance, as well as the continuing incidence of banking crises and speculative excesses.

We are grateful to Agustin Carstens, Anastasios Dosis, Kristin Forbes (discussant), Pierre-Olivier Gourinchas (discussant), Anil Kashyap, Cecilia Parlatore, Guillaume Plantin, Jeremy Stein, Bruce Tuckman, Olivier Wang, and seminar participants at the 24th BIS Annual Conference, Finance Theory Group Summer School 2025, and Stern Finance Reading Group for helpful discussions. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.

Viral V. Acharya
Previously circulated under the title “In the Shadow of Banks: Wealth Management Products and Issuing Banks’ Risks in China.” We are grateful for helpful comments from Victoria Ivashina (the Editor), an associate editor, two anonymous reviewers, Zhuo Chen, Quirin Fleckenstein, Kinda Hachem, Zhiguo He, Nirupama Kulkarni, Robert Marquez, Yiming Qian, Hong Ru, Tianyue Ruan, Vineet Srivastava, Hao Wang, Hao Zhou, and seminar/session participants at the Central Univ. of Finance & Economics, Fudan University, Korea University, NYU Stern, Shanghai Univ. of Finance & Economics, Tsinghua PBC School, University of Nottingham, Ningbo, Asian Econometric Meetings (Hong Kong), China International Conference in Finance (Xiamen), China Financial Research Conference, NBER China Working Group Meeting (Cambridge, MA), Princeton China Conference, Summer Institute of Finance, and the Western Finance Association meetings (Whistler, Canada). We gratefully acknowledge research assistance from Vanya Petrova, Dayou Xi, Yang Zhao, and financial support from Fudan University, NYU, and Tsinghua University Qian and Yang also acknowledge financial support from the National Natural Science Foundation of China (Grant #71972051 for Qian, and Grant #71272024 for Yang). The authors are responsible for all remaining errors.

Raghuram Rajan
Rajan is on paid advisory boards for BDT&MSD, Pimco, and RLUSD. He also delivers paid speeches for Citadel Securities. Details of these positions and engagements are registered with his employer, the University of Chicago, and are consistent with the University of Chicago's conflict of interest and conflict of commitment policies. None of this paper's research relied on funding from these entities.
MARC RIS BibTeΧ

When is Less More? Bank Arrangements for Liquidity vs Central Bank Support

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