When is less more? Bank arrangements for liquidity vs central bank support

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

No 1307, BIS Working Papers from Bank for International Settlements

Abstract: Theory suggests that in the face of fire-sale externalities, banks have incentives to overinvest in order to issue cheap 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 once again. 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, its subsequent disappearance, as well as the continuing incidence of banking crises and speculative excesses.

Keywords: banking crises; financial stability policies (search for similar items in EconPapers)
JEL-codes: E58 G01 G21 (search for similar items in EconPapers)
Date: 2025-11
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