Contagious Bank Runs and Committed Liquidity Support

Abstract

In a crisis, regulators and private investors can find it difficult, if not impossible, to tell whether banks facing runs are insolvent or merely illiquid. We introduce such an information constraint into a global-games-based bank run model with multiple banks and aggregate uncertainties. The information constraint creates a vicious cycle between contagious bank runs and falling asset prices and limits the effectiveness of traditional emergency liquidity assistance programs. We explain how a regulator can set up committed liquidity support to contain contagion and stabilize asset prices even without information on banks’ solvency, rationalizing some recent developments in policy practices. This paper was accepted by Agostino Capponi, finance.