Abstract: 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 suggests why private contingent capital dominated in the era preceding central banks and deposit insurance, why it waned subsequently, as well as why banking crises and speculative excesses continue to recur periodically.
Abstract: Banks can use the discount window to fend off a run by prepositioning assets with the Fed and borrowing against them. Following the March 2023 bank runs, policymakers have considered mandatory prepositioning, arguably the largest update to the lender-of-last-resort toolkit in over a century. We study the forces that shape the largest banks’ prepositioning. We show that run-prone uninsured-deposit flows causally drive prepositioning and that banks face a pre-positioning stigma, even absent borrowing. Prepositioning is no panacea — banks still need good assets to borrow against — but it can help at the margin.
Discussant: William Diamond, University of Wisconsin-Madison
Abstract: Using a newly-constructed panel dataset of U.S. states from 1863 to 2022 that combines bank balance sheets, real economic activity, and a systematic survey of all major chronologies of U.S. financial crises, we document the following facts: (i) financial crises are followed by a 6% decline in state-level output, (ii) output losses vary substantially across states, (iii) the severity of output losses is predictable with local contractions in deposits or wholesale liabilities, and with the incidence of bank failures, (iv) a composite measure of local financial distress, combining narrative evidence with statistical indicators, predicts state-level output losses of 3%, and (v) the share of states experiencing local financial distress predicts national output beyond a binary crisis indicator. These findings suggest that studies of systemic crises may underestimate the frequency and costs of financial distress.
