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Liquidity Shortages and Banking Crises

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Author Info
Douglas W. Diamond
Raghuram G. Rajan

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Abstract

Banks can fail either because they are insolvent or because an aggregate shortage of liquidity can render them insolvent. We show that bank failures can themselves cause liquidity shortages. The failure of some banks can then lead to a cascade of failures and a possible total meltdown of the system. Contagion here is not caused by contractual or informational links between banks but because bank failure could lead to a contraction in the common pool of liquidity. There is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact, and can each cause the other. It is therefore hard to determine the root cause of a crisis from observable factors. The practical difficulty of determining the most appropriate intervention, as well as the costs of the wrong kind of intervention (such as infusing capital when the need is for liquidity) have to be traded off against the costs of a meltdown, which can be substantial. We propose a robust sequence of intervention.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8937.

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Date of creation: May 2002
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Handle: RePEc:nbr:nberwo:8937

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  1. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December. [Downloadable!] (restricted)
  2. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August. [Downloadable!] (restricted)
  3. 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. [Downloadable!] (restricted)
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  4. Charles W. Calomiris & Gary Gorton, . "The Origins of Banking Panics: Models, Facts, and Bank Regulation," Rodney L. White Center for Financial Research Working Papers 11-90, Wharton School Rodney L. White Center for Financial Research.
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  5. Nobuhiro Kiyotaki & John Moore, 2004. "Inside Money and Liquidity," ESE Discussion Papers 115, Edinburgh School of Economics, University of Edinburgh.
  6. Diamond, Douglas-W, 2001. "Should Japanese Banks Be Recapitalized?," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(2), pages 1-19, May. [Downloadable!]
  7. Douglas W. Diamond & Raghuram G. Rajan, . "Banks, Short Term Debt and Financial Crises: Theory, Policy Implications and Applications."," CRSP working papers 518, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
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  8. Hart, Oliver & Moore, John, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 841-79, November. [Downloadable!] (restricted)
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  9. Stewart C. Myers & Raghuram G. Rajan, 1998. "The Paradox Of Liquidity," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 733-771, August. [Downloadable!] (restricted)
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  10. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, vol. 45(1), pages 49-71, March. [Downloadable!] (restricted)
  11. 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. [Downloadable!] (restricted)
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  12. Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
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  13. 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. [Downloadable!] (restricted)
  14. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Blackwell Publishing, vol. 51(3), pages 393-414, July. [Downloadable!] (restricted)
  15. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Banks and Liquidity," American Economic Review, American Economic Association, vol. 91(2), pages 422-425, May. [Downloadable!] (restricted)
  16. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
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  17. Ricardo Caballero & Arvind Krishnamurthy, 1998. "Emerging Market Crises: An Asset Markets Perspective," Working papers 98-18, Massachusetts Institute of Technology (MIT), Department of Economics.
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  18. Douglas W. Diamond & Raghuram G. Rajan, 2002. "Bank Bailouts and Aggregate Liquidity," American Economic Review, American Economic Association, vol. 92(2), pages 38-41, May. [Downloadable!]
  19. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February. [Downloadable!] (restricted)
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  20. Hellwig, Martin, 1994. "Liquidity provision, banking, and the allocation of interest rate risk," European Economic Review, Elsevier, vol. 38(7), pages 1363-1389, August. [Downloadable!] (restricted)
  21. Anil K. Kashyap & Raghuram Rajan & Jeremy C. Stein, 1999. "Banks as Liquidity Providers: An Explanation for the Co-Existence of Lending and Deposit-Taking," NBER Working Papers 6962, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  22. Diamond, Douglas W, 1997. "Liquidity, Banks, and Markets," Journal of Political Economy, University of Chicago Press, vol. 105(5), pages 928-56, October.
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  23. Bernanke, Ben S, 1983. "Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression," American Economic Review, American Economic Association, vol. 73(3), pages 257-76, June. [Downloadable!] (restricted)
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  24. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
  25. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April. [Downloadable!] (restricted)
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  26. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June. [Downloadable!] (restricted)
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  27. 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, vol. 96(3), pages 568-92, June. [Downloadable!] (restricted)
  28. Rajan, Raghuram G, 1992. " Insiders and Outsiders: The Choice between Informed and Arm's-Length Debt," Journal of Finance, American Finance Association, vol. 47(4), pages 1367-400, September. [Downloadable!] (restricted)
  29. Goodfriend, M. & King, R.G., 1988. "Financial Deregulation, Monetary Policy, And Central Banking," RCER Working Papers 121, University of Rochester - Center for Economic Research (RCER).
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  30. Qi, Jianping, 1998. "Deposit Liquidity and Bank Monitoring," Journal of Financial Intermediation, Elsevier, vol. 7(2), pages 198-218, April. [Downloadable!] (restricted)
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