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Liquidity risk, liquidity creation and financial fragility: a theory of banking

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  • Douglas W. Diamond
  • Raghuram G. Rajan

Abstract

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. We argue that financial intermediation 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 somewhat fragile capital structure, subject to bank runs, in ordre to perform these functions. A number of institutional featurs of a bank are therefore 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.

Suggested Citation

  • Douglas W. Diamond & Raghuram G. Rajan, 1998. "Liquidity risk, liquidity creation and financial fragility: a theory of banking," Proceedings, Federal Reserve Bank of San Francisco, issue sep.
    • Handle: RePEc:fip:fedfpr:y:1998:i:sep:x:1
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