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Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking

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  • Douglas W. Diamond
  • Raghuram G. Rajan

Abstract

Both investors and borrowers are concerned about liquidity. Investors desire liquidity because they are uncertain about when they will want to eliminate their holding of a financial asset. Borrowers are concerned about liquidity because they are uncertain about their ability to continue to attract or retain funding. Because borrowers typically cannot repay investors on demand, investors will require a premium or significant control rights when they lend to borrowers directly, as compensation for the illiquidity investors will be subject to. We argue that banks can resolve these liquidity problems that arise in direct lending. Banks enable depositors to withdraw at low cost, as well as buffer firms from the liquidity needs of their investors. We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions. Far from being an aberration to be regulated away, the funding of illiquid loans by a bank with volatile demand deposits is rationalized in the context of the functions it performs. This model can be used to investigate important issues such as narrow banking and bank capital requirements.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7430.

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Date of creation: Dec 1999
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Publication status: published as Journal of Political Economy, Vol. 109, no. 2 (April 2001): 287-327
Handle: RePEc:nbr:nberwo:7430

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  1. Qi, Jianping, 1998. "Deposit Liquidity and Bank Monitoring," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 7(2), pages 198-218, April.
  2. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  3. Boyd, John H. & Prescott, Edward C., 1986. "Financial intermediary-coalitions," Journal of Economic Theory, Elsevier, vol. 38(2), pages 211-232, April.
  4. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  5. 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.
  6. Hart, O. & Moore, J., 1991. "A Theory of Debt Based on the Inalienability of Human Capital," Working papers 592, Massachusetts Institute of Technology (MIT), Department of Economics.
  7. Stewart C. Myers & Raghuram G. Rajan, 1995. "The Paradox of Liquidity," NBER Working Papers 5143, National Bureau of Economic Research, Inc.
  8. Erik Berglof & Ernst-Ludwig von Thadden, 1994. "Capital Structure with Multiple Investors," CEPR Financial Markets Paper, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ 0044, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
  9. Bengt Holmstrom & Jean Tirole, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," Working papers 95-1, Massachusetts Institute of Technology (MIT), Department of Economics.
  10. Diamond, Douglas W. & Rajan, Raghuram G., 2001. "Banks, short-term debt and financial crises: theory, policy implications and applications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 54(1), pages 37-71, June.
  11. Anil K. Kashyap & Raghuram Rajan & Jeremy C. Stein, 2002. "Banks as Liquidity Providers: An Explanation for the Coexistence of Lending and Deposit-Taking," Journal of Finance, American Finance Association, American Finance Association, vol. 57(1), pages 33-73, 02.
  12. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
  13. Steven A. Sharpe, 1989. "Asymmetric information, bank lending, and implicit contracts: a stylized model of customer relationships," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 70, Board of Governors of the Federal Reserve System (U.S.).
  14. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(1), pages 1-25, February.
  15. Douglas W. Diamond, . "Liquidity, Banks and Markets," CRSP working papers 326, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  16. Douglas W. Diamond & Raghuram G. Rajan, 2000. "A Theory of Bank Capital," Journal of Finance, American Finance Association, American Finance Association, vol. 55(6), pages 2431-2465, December.
  17. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
  18. Greenbaum, Stuart I. & Kanatas, George & Venezia, Itzhak, 1989. "Equilibrium loan pricing under the bank-client relationship," Journal of Banking & Finance, Elsevier, vol. 13(2), pages 221-235, May.
  19. Mark J. Flannery, 1991. "Debt maturity and the deadweight cost of leverage: optimally financing banking firms," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Nov.
  20. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, American Finance Association, vol. 47(4), pages 1343-66, September.
  21. 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.
  22. 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.
  23. 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.
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  1. Reflections on a Year of Crisis
    by Barry Ritholtz in the big picture on 2009-08-21 14:30:12
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