Liquidity Shortages and Banking Crises

Douglas W. Diamond and Raghuram G. Rajan

Journal of Finance, 2005, vol. 60, issue 2, pages 615-647

Abstract: 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.

Date: 2005
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Working Paper: Liquidity Shortages and Banking Crises (2003)
Working Paper: Liquidity Shortages and Banking Crises (2002)
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