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Liquidity Shortages and Banking Crises

  • DOUGLAS W. DIAMOND
  • RAGHURAM G. RAJAN

We show in this article that bank failures can be contagious. Unlike earlier work where contagion stems from depositor panics or contractual links between banks, we argue that bank failures can shrink the common pool of liquidity, creating, or exacerbating aggregate liquidity shortages. This could lead to a contagion of failures and a total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity and solvency problems interact and can cause each other, making it hard to determine the cause of a crisis. We propose a robust sequence of intervention. Copyright 2005 by The American Finance Association.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 60 (2005)
Issue (Month): 2 (04)
Pages: 615-647

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Handle: RePEc:bla:jfinan:v:60:y:2005:i:2:p:615-647
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  1. Marvin Goodfriend & Robert G. King, 1988. "Financial deregulation, monetary policy, and central banking," Working Paper 88-01, Federal Reserve Bank of Richmond.
  2. Moore, John Hardman, 2009. "Money and Liquidity," SIRE Focus Papers 2009-01, Scottish Institute for Research in Economics (SIRE).
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