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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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Paper provided by Center for Research in Security Prices, Graduate School of Business, University of Chicago in its series CRSP working papers with number 518.

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Handle: RePEc:wop:chispw:518

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  1. Douglas W. Diamond & Raghuram G. Rajan, . "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," CRSP working papers 476, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  2. Dani Rodrik & Andres Velasco, 1999. "Short-Term Capital Flows," NBER Working Papers 7364, National Bureau of Economic Research, Inc.
  3. 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.
  4. Douglas W. Diamond & Raghuram G. Rajan, 1999. "A Theory of Bank Capital," NBER Working Papers 7431, National Bureau of Economic Research, Inc.
  5. Michael P. Dooley, 1998. "A model of crises in emerging markets," International Finance Discussion Papers 630, Board of Governors of the Federal Reserve System (U.S.).
  6. Roberto Chang & Andres Velasco, 1999. "Liquidity Crises in Emerging Markets: Theory and Policy," NBER Working Papers 7272, National Bureau of Economic Research, Inc.
  7. Michael P. Dooley & Inseok Shin, 2000. "Private Inflows when Crises are Anticipated: A Case Study of Korea," NBER Working Papers 7992, National Bureau of Economic Research, Inc.
  8. Demirguc-Kunt, Asli & Detragiache, Enrica, 1997. "The determinants of banking crises : evidence from industrial and developing countries," Policy Research Working Paper Series 1828, The World Bank.
  9. 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.
  10. Pomerleano, Michael, 1998. "The East Asia crisis and corporate finances : the untold micro story," Policy Research Working Paper Series 1990, The World Bank.
  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, vol. 57(1), pages 33-73, 02.
  12. 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.
  13. Steven Radelet & Jeffrey D. Sachs, 1998. "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1), pages 1-90.
  14. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  15. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
  16. Raghuram G. Rajan & Luigi Zingales, 1998. "Which Capitalism? Lessons from the East Asian Crisis," CRSP working papers 486, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  17. Timothy D. Lane & Marianne Schulze-Gattas & T. M. Tsikata & Steven Phillips & Atish R. Ghosh & A. Javier Hamann, 1999. "IMF-Supported Programs in Indonesia, Korea and Thailand," IMF Occasional Papers 178, International Monetary Fund.
  18. 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.
  19. Asli Demirgüç-Kunt & Enrica Detragiache, 1997. "The Determinants of Banking Crises," IMF Working Papers 97/106, International Monetary Fund.
  20. Oliver Hart & John Moore, 1991. "A Theory of Debt Based on the Inalienability of Human Capital," NBER Working Papers 3906, National Bureau of Economic Research, Inc.
  21. 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.
  22. Jeanne, Olivier, 2000. "Foreign currency debt and the global financial architecture," European Economic Review, Elsevier, vol. 44(4-6), pages 719-727, May.
  23. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
  24. 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.
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