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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
7430.
Length: Date of creation: Dec 1999 Date of revision: Publication status: published as Updated September 12, 2000 Handle: RePEc:nbr:nberwo:7430
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Douglas W. Diamond & Raghuram G. Rajan, 2000.
"A Theory of Bank Capital,"
Journal of Finance,
American Finance Association, vol. 55(6), pages 2431-2465, December.
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Other versions:
Douglas W. Diamond & Raghuram G. Rajan, .
"A Theory of Bank Capital,"
CRSP working papers
363, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
Stewart C. Myers & Raghuram G. Rajan, 1998.
"The Paradox of Liquidity,"
CRSP working papers
339, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
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