Cash out or carry on: When bank runs build resilience

Abstract

We integrate liquidity risk into a first passage time solvency model to measure the joint probability of bank default. Counterintuitively, we find that the interaction between liquidity and solvency risks can, under plausible conditions, lower the overall likelihood of default. This finding is significant to the supply of credit to the real economy, as it reduces the pressure on banks to scale back risk-taking by tightening lending conditions after negative liquidity shocks. As far as we know, our combined liquidity-solvency model is the first to demonstrate this stabilizing effect.