Date Added: Aug 2009
When banks have relative expertise in employing risky assets, the market for these assets clears only at re-sale prices following a large number of bank failures. The gains from acquiring assets at re-sale prices make it attractive for banks to hold liquid assets. The resulting choice of bank liquidity is counter-cyclical, inefficiently low during economic booms but excessively high during crises. The authors present evidence consistent with these predictions. While interventions to resolve banking crises may be desirable ex post, they affect bank liquidity in subtle ways: liquidity support to failed banks or unconditional support to surviving banks reduces incentives to hold liquidity, whereas support to surviving banks conditional on their liquid asset holdings has the opposite effect.