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A Theory of Bank Capital

Listed author(s):
  • Douglas W. Diamond
  • Raghuram G. Rajan

Banks can create liquidity because their deposits are fragile and prone to runs. Increased uncertainty can make deposits excessively fragile in which case there is a role for outside bank capital. Greater bank capital reduces liquidity creation by the bank but enables the bank to survive more often and avoid distress. A more subtle effect is that banks with different amounts of capital extract different amounts of repayment from borrowers. The optimal bank capital structure trades off the effects of bank capital on liquidity creation, the expected costs of bank distress, and the ease of forcing borrower repayment. The model can account for phenomena such as the decline in average bank capital in the United States over the last two centuries. It points to overlooked side-effects of policies such as regulatory capital requirements and deposit insurance.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7431.

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Date of creation: Dec 1999
Publication status: published as Diamond, Douglas W. and Raghuram G. Rajan. "A Theory Of Bank Capital," Journal of Finance, 2000, v55(6,Dec), 2431-2465.
Handle: RePEc:nbr:nberwo:7431
Note: CF ME
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