Systemic banking panics, liquidity risk, and monetary policy

Abstract

I present a general equilibrium monetary model of banking with multiple equilibria. In the good equilibrium, all banks are solvent. In the bad equilibrium, a fraction of banks in the economy are insolvent and subject to runs. The bad equilibrium is also characterized by deflation and a flight to liquidity, and matches other stylized facts of systemic financial crises. The multiplicity of equilibria arises from a strategic complementarity in the decision to fly to liquidity. A sufficiently large monetary injection eliminates the bad equilibrium. However, the size of the monetary injection required to eliminate the equilibrium is smaller if the central bank provides loans to banks, in comparison to using an asset purchase policy. This is because loans to banks are equivalent to asset purchases coupled with partial deposit insurance.