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Liquidity, banks, and markets : effects of financial development on banks and the maturity of financial claims

Author

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  • Diamond, Douglas W.

Abstract

Financial markets and financial institutions compete to provide investors with liquidity. The author examines the roles of banks and markets when both are active, characterizing how development of the financial markets affects the structure and market share of banks. Banks create liquidity by offering claims with a higher short-term return than exist without a banking system. The amount of liquidity that banks offer depends on the degree of direct participation in financial markets - that is, on the liquidity of financial markets. Conversely, banks influence the amount of liquidity offered by financial markets. As more investors participate in financial markets, allowing markets to provide liquidity, banks shrink and makefewer long-term loans. Moreover, the banking sector's ability to subsidize those with immediate liquidity needs is reduced. More liquid markets also lead to physical investment with longer maturity, a smaller gap between the maturity of financial assets and that of phycial investments. Financial assets have a shorter maturity than physical investments, but this gap approaches zero as the market approaches full liquidity. The author provides an analytical basis for developing short-term markets as a way to stimulate the supply of long-term finance, and he supports the practitioner's view that short-term financial markets are a prerequisite for the development of viable long-term finance.

Suggested Citation

  • Diamond, Douglas W., 1996. "Liquidity, banks, and markets : effects of financial development on banks and the maturity of financial claims," Policy Research Working Paper Series 1566, The World Bank.
  • Handle: RePEc:wbk:wbrwps:1566
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    References listed on IDEAS

    as
    1. Haubrich, Joseph G. & King, Robert G., 1990. "Banking and insurance," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 361-386, December.
    2. Hellwig, Martin, 1994. "Liquidity provision, banking, and the allocation of interest rate risk," European Economic Review, Elsevier, vol. 38(7), pages 1363-1389, August.
    3. 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.
    4. Hoshi, Takeo & Kashyap, Anil & Scharfstein, David, 1990. "The role of banks in reducing the costs of financial distress in Japan," Journal of Financial Economics, Elsevier, vol. 27(1), pages 67-88, September.
    5. Demirguc-Kunt, Ash & Levine, Ross, 1996. "Stock Market Development and Financial Intermediaries: Stylized Facts," World Bank Economic Review, World Bank Group, vol. 10(2), pages 291-321, May.
    6. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
    7. Allen, Franklin & Gale, Douglas, 1994. "Limited Market Participation and Volatility of Asset Prices," American Economic Review, American Economic Association, vol. 84(4), pages 933-955, September.
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    Cited by:

    1. Fluck, Zsuzsanna & John, Kose & Ravid, S. Abraham, 2007. "Privatization as an agency problem: Auctions versus private negotiations," Journal of Banking & Finance, Elsevier, vol. 31(9), pages 2730-2750, September.

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