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provide demand and other short-term deposits on a fractional

reserve basis, banks have a much greater liquidity and dura-

tion mismatch between assets and liabilities than do nonfi-

nancial firms.  That mismatch makes banks particularly sen-

sitive to sudden large withdrawals of funds (bank runs) that

cannot be met in full and on time by the banks' cash and

liquid asset holdings.10  Banks thus may be required to sell

assets quickly.  To the extent that those assets are not

traded in highly liquid markets, the banks may suffer fire-

sale losses that may exceed their small capital base and

drive them into insolvency.  The duration mismatch also ex-

poses banks to interest rate risk so that abrupt changes in

interest rates can induce (realized and unrealized) losses

that can quickly exceed their capital.

Such concerns about bank instability have provided a

rationale for restricting the types of assets that a bank

can hold in its portfolio.  Part of the rationale for main-

taining the Glass-Steagall Act is to shield banks from expo-

sure to many types of risks, particularly those of holding

equity instruments.  Some people have gone further to argue

for even greater restrictions on bank assets and bank activ-

ities.  Some "narrow bank" proposals, for example, would re-

quire banks to hold 100 percent reserves of liquid, short-

term government bonds to address and remedy the two main

causes of individual bank fragility just discussed.11

In addition to concerns about the stability of individ-

ual banks, there is concern that the banking system is par-

ticularly fragile because of the close interconnectedness of

banks through interbank deposits and lending.  Losses at any

one bank may thus produce losses at other banks, which can

cascade throughout the banking system.  Moreover, if deposi-

tors are unable to differentiate among the financial health

of individual banks, troubles at one or a few institutions

could spread quickly throughout the system as uninformed

depositors withdraw funds indiscriminately from depository

institutions regardless of their financial fundamentals.  In

the absence of offsetting actions by the central bank, such

runs from deposits at banks will worsen fire-sale losses,

increase the number of bank failures, and cause a multiple

contraction of money and credit and macroeconomic in-

stability.

The fragility of banks and the banking system in the

absence of a government safety net, however, may be overem-

phasized.  First, bank failures spread throughout the system

only if losses exceed a bank's capital by enough to produce

losses at creditor banks that exceed their capital and, in

turn, force them into insolvency.  If losses associated with