Crisis Resolution and Bank Liquidity

Abstract

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 counter-cyclical, 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.J.E.L. Classification: G21, G28, G32, E58, D61

Bank Cash Holdings and Investor Uncertainty

“…A possible explanation is that stockholders are worried about the agency costs of free cash flows. This hypothesis is consistent with Acharya et al (2011), who suggest that banks may have incentives during crises to hold liquid assets in order to purchase assets from other failing banks at fire sale prices. The opacity of such transactions and the purchased assets may unnerve stockholders.…”

“…Also, Cornett et al 9 (2011) find that, during the financial crisis of 2007-2009, banks holding more illiquid asset portfolios increased their liquidity buffer and reduced lending. Alternatively, Acharya et al (2011) contend that, during crises, seemingly precautionary cash positions may in fact be war chests created to purchase assets from other failing banks at fire sale prices. Similarly, Wagner (2007b) advances that increased asset liquidity may induce excessive risk-taking during crisis periods, leading to greater bank fragility and lower overall systemic stability.…”

“…While perhaps puzzling at first glance, this effect may be related to the agency risks presented by large cash positions. Large cash positions may make stockholders anxious, especially if there are few demandable deposits to discipline managers, who might, for example, be driven to acquire fire sale assets when other banks get into trouble (Acharya et al, 2011). Such moves may unnerve investors, since the acquired assets are opaque and the times, uncertain.…”

Bank capital, interbank contagion, and bailout policy

“…Our results on bailout policy also complement the findings of Acharya, Shin, and Yorulmazer (2010) that government support to surviving banks conditional on their liquid asset holdings increases banks' incentive to hold liquidity, and that support to failed banks or unconditional support to surviving banks has the opposite effect. While their study stresses the role of banks' asset composition, our focus is the role of banks' capital holdings in anticipation of common stock or preferred equity bailout.…”

Leverage and preemptive selling of financial institutions

“…In this sense, it relates to Allen and Gale (2004), Gorton and Huang (2004), and Acharya, Shin, and Yorulmazer (2009). These papers model situations in which some investors decide to "stand by" and hold liquid, safe, but low-yielding assets.…”