May 2002.

Banks can fail either because they are insolvent or because an aggregate shortage of liquidity can render them insolvent. We show that bank failures can themselves cause liquidity shortages. The failure of some banks can then lead to a cascade of failures and a possible total meltdown of the system. Contagion here is not caused by contractual or informational links between banks but because bank failure could lead to a contraction in the common pool of liquidity. There is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact, and can each cause the other. It is therefore hard to determine the root cause of a crisis from observable factors. The practical difficulty of determining the most appropriate intervention, as well as the costs of the wrong kind of intervention (such as infusing capital when the need is for liquidity) have to be traded off against the costs of a meltdown, which can be substantial. We propose a robust sequence of intervention.

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