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Banks, Short Term Debt and Financial Crises: Theory, Policy Implications and Applications

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  • Douglas W. Diamond
  • Raghuram G. Rajan

Abstract

Short-term borrowing has often been blamed for precipitating financial crises. We argue that while the empirical association between a financial institution's, or country's, short-term borrowing and susceptibility to crises may, in fact, exist, the direction of causality is often precisely the opposite to the one traditionally suggested by commentators. Institutions like banks that want to enhance their ability to provide liquidity and credit to difficult borrowers have to borrow short-term. Similarly countries that have poor disclosure rules and inadequate investor protections, have limited long-term debt capacity, and will find their borrowing becoming increasingly short-term as they finance illiquid investment. Thus it is the increasing illiquidity of the investment being financed (or the deteriorating credit quality of borrowers) that necessitates short-term financing, and causes the susceptibility to crises. In fact, once illiquid investments have been financed, rather than making the system more stable, a ban on short-term financing may precipitate a more severe crisis. Even a priori, a ban is not without adverse consequences policy makers have to trade off the costs of decreased credit creation and investment against the benefits of greater stability. A ban on short-term debt often deals with symptoms rather than underlying causes.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7764.

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Date of creation: Jun 2000
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Publication status: published as 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, vol. 54(1), pages 37-71, June.
Handle: RePEc:nbr:nberwo:7764

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  1. 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.
  2. 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.
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  6. Pomerleano, Michael, 1998. "The East Asia crisis and corporate finances : the untold micro story," Policy Research Working Paper Series 1990, The World Bank.
  7. 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.
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  18. 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.
  19. Raghuram G. Rajan & Luigi Zingales, 1998. "Which Capitalism? Lessons Form The East Asian Crisis," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 11(3), pages 40-48.
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  21. 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.
  22. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, American Finance Association, vol. 60(2), pages 615-647, 04.
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