How do the liquidity functions of banks affect investment and growth at different stages of economic development? How do financial fragility and the costs of banking crises evolve with the level of wealth of countries? We analyze these issues using an overlapping generations growth model where agents, who experience idiosyncratic liquidity shocks, can invest in a liquid storage technology or in a partially illiquid Cobb-Douglas technology. By pooling liquidity risk, banks play a growth-ancing role in reducing ineffcient liquidation of long-term projects, but they may face liquidity crises associated with severe output losses. We show that middle-income economies may find it optimal to be exposed to liquidity crises, while poor and rich economies have more incentives to develop a fully covered banking system.
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