Liquidity risk and bank portfolio management in a financial system without deposit insurance: Empirical evidence from prewar Japan

Using data from prewar Japan, this paper investigates the impact of a liquidity shock induced by depositors behavior on bank portfolio management during financial crises in a system lacking deposit insurance. It is found that banks reacted to the liquidity shock sensitively through an increase in their cash holdings not by liquidating bank loans but by selling securities in the financial market. Moreover, banks exposed to local financial contagion adjusted the liquidity of their portfolio mainly by actively selling and buying their securities in the financial market. Finally, there is no evidence to conclude that the existence of the lender of last resort mitigated the liquidity constraints in bank portfolio adjustments. (C) 2009 Elsevier Inc. All rights reserved.