Public Liquidity and Financial Crises

This paper studies the equilibrium effect of public liquidity on financial crises. Banks borrow from households via insured deposits and partially runnable debt and suffer endogenous funding withdrawals from households in crises. Holding public liquidity alleviates banks’ liquidity problems. In equilibrium, a larger public liquidity supply reduces crisis severity and expands bank lending but crowds bank deposits and increases bank vulnerability to real shocks. The model quantitatively explains 40 percent of Treasury liquidity premium variations. Counterfactual analyses reveal that QE1 significantly improves output, 20 times larger than QE3. However, QE policies raise bank fragility against nonfinancial shocks such as COVID-19. (JEL E23, E32, E44, E52, E58, G01, G21)