This paper shows that an increased liquidity of bank assets, paradoxically, increases
banking instability and the externalities associated with banking failures. This is because
even though higher asset liquidity directly benefits stability by encouraging banks to reduce
the risks on their balance sheets and by facilitating the liquidation of assets in a crisis, it also
makes crises less costly for banks. As a result, banks have an incentive to take on an
amount of new risk that more than offsets the positive direct impact on stability.