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Liquidity Shortages and Banking Crises

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  • Douglas W. Diamond
  • Raghuram G. Rajan

Abstract

We show in this paper that bank failures can be contagious. Unlike earlier work where contagion stems from depositor panics or ex ante contractual links between banks, we argue bank failures can shrink the common pool of liquidity, creating or exacerbating aggregate liquidity shortages. This could lead to a contagion of failures and a possible total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact and can cause each other, making it hard to determine the root cause of a crisis from observable factors. We propose a robust sequence of intervention.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10071.

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Date of creation: Nov 2003
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Publication status: published as Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, 04.
Handle: RePEc:nbr:nberwo:10071

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  1. Douglas W. Diamond & Raghuram G. Rajan, 1999. "A Theory of Bank Capital," NBER Working Papers 7431, National Bureau of Economic Research, Inc.
  2. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(3), pages 663-91, August.
  3. Douglas W. Diamond & Raghuram G. Rajan, 2000. "Banks, Short Term Debt and Financial Crises: Theory, Policy Implications and Applications," NBER Working Papers 7764, National Bureau of Economic Research, Inc.
  4. Ben S. Bernanke, 1983. "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression," NBER Working Papers 1054, National Bureau of Economic Research, Inc.
  5. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  6. Ricardo J. Caballero & Arvind Krishnamurthy, 2000. "International Liquidity Management: Sterilization Policy in Illiquid Financial Markets," NBER Working Papers 7740, National Bureau of Economic Research, Inc.
  7. Ricardo Caballero & Arvind Krishnamurthy, 1999. "Emerging Market Crises: An Asset Markets Perspective," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 99-23, Massachusetts Institute of Technology (MIT), Department of Economics.
  8. Stewart C. Myers & Raghuram G. Rajan, 1998. "The Paradox of Liquidity," CRSP working papers, Center for Research in Security Prices, Graduate School of Business, University of Chicago 339, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  9. Donaldson, R. Glen, 1992. "Costly liquidation, interbank trade, bank runs and panics," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 2(1), pages 59-82, March.
  10. Hart, Oliver & Moore, John, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 109(4), pages 841-79, November.
  11. Anil Kashyap & Raghuram Rajan & Jeremy S. Stein, 1998. "Banks as liquidity providers: an explanation for the co-existence of lending and deposit-taking," Proceedings, Federal Reserve Bank of Chicago 582, Federal Reserve Bank of Chicago.
  12. Jacklin, Charles J & Bhattacharya, Sudipto, 1988. "Distinguishing Panics and Information-Based Bank Runs: Welfare and Policy Implications," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 96(3), pages 568-92, June.
  13. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  14. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, American Finance Association, vol. 45(1), pages 49-71, March.
  15. Douglas W. Diamond & Raghuram G. Rajan, 2006. "Money in a Theory of Banking," American Economic Review, American Economic Association, American Economic Association, vol. 96(1), pages 30-53, March.
  16. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, Elsevier, vol. 4(4), pages 335-344, December.
  17. Douglas W. Diamond & Raghuram G. Rajan, . "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," CRSP working papers, Center for Research in Security Prices, Graduate School of Business, University of Chicago 476, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  18. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  19. Charles W. Calomiris & Gary Gorton, 1991. "The Origins of Banking Panics: Models, Facts, and Bank Regulation," NBER Chapters, National Bureau of Economic Research, Inc, in: Financial Markets and Financial Crises, pages 109-174 National Bureau of Economic Research, Inc.
  20. Diamond, Douglas W, 1997. "Liquidity, Banks, and Markets," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 105(5), pages 928-56, October.
  21. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, American Economic Association, vol. 81(3), pages 497-513, June.
  22. Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  23. Marvin Goodfriend & Robert G. King, 1988. "Financial deregulation, monetary policy, and central banking," Working Paper, Federal Reserve Bank of Richmond 88-01, Federal Reserve Bank of Richmond.
  24. Diamond, Douglas-W, 2001. "Should Japanese Banks Be Recapitalized?," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(2), pages 1-19, May.
  25. Hellwig, Martin, 1994. "Liquidity provision, banking, and the allocation of interest rate risk," European Economic Review, Elsevier, Elsevier, vol. 38(7), pages 1363-1389, August.
  26. Qi, Jianping, 1998. "Deposit Liquidity and Bank Monitoring," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 7(2), pages 198-218, April.
  27. Rajan, Raghuram G, 1992. " Insiders and Outsiders: The Choice between Informed and Arm's-Length Debt," Journal of Finance, American Finance Association, American Finance Association, vol. 47(4), pages 1367-400, September.
  28. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Banks and Liquidity," American Economic Review, American Economic Association, American Economic Association, vol. 91(2), pages 422-425, May.
  29. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  30. Douglas W. Diamond & Raghuram G. Rajan, 2002. "Bank Bailouts and Aggregate Liquidity," American Economic Review, American Economic Association, American Economic Association, vol. 92(2), pages 38-41, May.
  31. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 106(3), pages 709-37, August.
  32. Moore, John Hardman, 2009. "Money and Liquidity," SIRE Focus Papers, Scottish Institute for Research in Economics (SIRE) 2009-01, Scottish Institute for Research in Economics (SIRE).
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