Central banks can operate with negative equity, and many have done so in history without undermining trust in fiat money. However, there are limits. How negative can central bank equity be before fiat money loses credibility? We address this question using a global games approach motivated by the fall of the Bank of Amsterdam (1609–1820). We solve for the unique break point where negative equity and asset illiquidity renders fiat money worthless. We draw lessons on the role of fiscal support and central bank capital in sustaining trust in fiat money.

We provide a theoretical framework to analyze the market maker of last resort (MMLR) role of central banks. Central bank announcement to purchase assets in case of distress promotes private agents’ willingness to make markets, which immediately restores liquidity to prevent disorderly sales. This, in turn, decreases the future need for the central bank to intervene. Here, the central bank can reduce the expected usage of the facility by announcing a large capacity, that is, it can end up buying less ex-post by committing to do more ex-ante. However, this beneficial feature comes with potential downsides. First, the central bank may not achieve the intended outcome due to the possibility of multiple self-fulfilling equilibria, which may arise if it does not intervene with sufficient aggression or if market participants have doubts about its commitment. Second, public liquidity provision may crowd out private liquidity if the MMLR access becomes permanent and make the intervention ineffective.

Financial regulation has led banks to increase their equity ratios. Yet, several studies find that this has not led to a decrease in bank equity risk. We show theoretically, that keeping less capital in excess of the minimum capital requirement can outweigh the risk-reducing effect on equity of increased total capitalization. Empirically, we find that excess capitalization is a significant determinant of equity risk, and can explain why bank equity risk has not become lower after the Great Financial Crisis. Smaller excess capitalization also leads to decreases in market-to-book ratios. Lower leverage has, however, reduced the cost of bank debt.