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What is the effect of financial crises and their resolution on banks' choice of liquidity? When banks have relative expertise in employing risky assets, the market for these assets clears only at fire-sale prices following a large number of bank failures. The gains from acquiring assets at fire-sale prices make it attractive for banks to hold liquid assets. The resulting choice of bank liquidity is countercyclical, inefficiently low during economic booms but excessively high during crises. We 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. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.
Acharya et al. (Wed,) studied this question.