DP10017 | Banks Are Where The Liquidity Is

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What is so special about banks that their demise often triggers government intervention? In this paper we show that, even ignoring interconnectedness issues, the failure of a bank causes a larger welfare loss than the failure of other institutions. The reason is that agents in need of liquidity tend to concentrate their holdings in banks. Thus, a shock to banks disproportionately affects the agents who need liquidity the most, reducing aggregate demand and the level of economic activity. The optimal fiscal response to such a shock is to help people, not banks, and the size of this response should be larger if a bank, rather than a similarly-sized nonfinancial firm, fails.