DP10017 Banks Are Where The Liquidity Is

Author(s): Oliver Hart, Luigi Zingales
Publication Date: June 2014
Keyword(s): bailout, banking, Liquidity
JEL(s): E41, E51, G21
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10017

What is so special about banks that their demise often triggers government intervention? In this paper we show that, 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. 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.