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

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.