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Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking

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Listed author(s):
  • 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. Because borrowers typically cannot repay investors on demand, investors will require a premium or significant control rights when they lend to borrowers directly, as compensation for the illiquidity investors will be subject to. We argue that banks 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 fragile capital structure, subject to bank runs, in order to perform these functions. Far from being an aberration to be regulated away, the funding of illiquid loans by a bank with volatile demand deposits is 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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7430.

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Date of creation: Dec 1999
Publication status: published as Journal of Political Economy, Vol. 109, no. 2 (April 2001): 287-327
Handle: RePEc:nbr:nberwo:7430
Note: CF ME
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Find related papers by JEL classification:
  • G20 - Financial Economics - - Financial Institutions and Services - - - General
  • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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  1. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-1366, September.
  2. Sharpe, Steven A, 1990. " Asymmetric Information, Bank Lending, and Implicit Contracts: A Stylized Model of Customer Relationships," Journal of Finance, American Finance Association, vol. 45(4), pages 1069-1087, September.
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  4. Stewart C. Myers & Raghuram G. Rajan, 1998. "The Paradox of Liquidity," The Quarterly Journal of Economics, Oxford University Press, vol. 113(3), pages 733-771.
  5. 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.
  6. Bengt Holmstrom & Jean Tirole, 1997. "Financial Intermediation, Loanable Funds, and The Real Sector," The Quarterly Journal of Economics, Oxford University Press, vol. 112(3), pages 663-691.
  7. 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.
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  9. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February.
  10. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  11. 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 568-592, June.
  12. Boyd, John H. & Prescott, Edward C., 1986. "Financial intermediary-coalitions," Journal of Economic Theory, Elsevier, vol. 38(2), pages 211-232, April.
  13. 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.
  14. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
  15. 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.
  16. Erik Berglöf & Ernst-Ludwig von Thadden, 1994. "Short-Term versus Long-Term Interests: Capital Structure with Multiple Investors," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 1055-1084.
  17. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, vol. 45(1), pages 49-71, March.
  18. 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.
  19. Hart, Oliver, 1995. "Firms, Contracts, and Financial Structure," OUP Catalogue, Oxford University Press, number 9780198288817.
  20. Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Oxford University Press, vol. 51(3), pages 393-414.
  21. Erik Berglof & Ernst-Ludwig von Thadden, 1994. "Capital Structure with Multiple Investors," CEPR Financial Markets Paper 0044, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ..
  22. Oliver Hart & John Moore, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 841-879.
  23. Flannery, Mark J, 1994. "Debt Maturity and the Deadweight Cost of Leverage: Optimally Financing Banking Firms," American Economic Review, American Economic Association, vol. 84(1), pages 320-331, March.
  24. 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 1367-1400, September.
  25. Qi, Jianping, 1998. "Deposit Liquidity and Bank Monitoring," Journal of Financial Intermediation, Elsevier, vol. 7(2), pages 198-218, April.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Reflections on a Year of Crisis
    by Barry Ritholtz in the big picture on 2009-08-21 14:30:12
  2. Making Finance Safe
    by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2014-10-06 12:30:15
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