Emergency liquidity injections

Abstract

This paper models emergency liquidity injection policies intended to prevent illiquidity-driven bank failures. A system-wide withdrawal of funding liquidity causes bank failures if banks’ securities have low market liquidity relative to the withdrawal size. The model presents several policy implications. Requiring banks to collateralise emergency lending with illiquid securities has positive externalities in the securities’ secondary markets, by constraining banks’ fire selling. For penalty rates on emergency lending to credibly mitigate moral hazard, the loans should be long term, due after the liquidity distress subsides. Additional policy implications relate to penalty rates, haircuts and government balance-sheet expansion.