Bank Bailouts and Aggregate Liquidity

The critical point made by Diamond and Rajan is that, while it is well understood that aggregate liquidity conditions can affect bank solvency, it is less well understood but equally important to note that bank solvency can affect aggregate liquidity. Depending on the characteristics of the banks that are in danger of failing, their failure can either subtract from the aggregate pool of liquidity or add to it. As is shown, it may be possible that the natural sequence of bailouts leads to an escalating set of bailouts, which culminates only when the government has no more resources to infuse. More generally, bailout decisions that increase the excess demand for liquidity can cause further insolvencies, and indeed, a meltdown of the entire system, where contagion is spread via the common pool of liquidity.