Liquidity Shortages and Banking Crises

Douglas W. Diamond and Raghuram G. Rajan

No 10071, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We show in this paper that bank failures can be contagious. Unlike earlier work where contagion stems from depositor panics or ex ante contractual links between banks, we argue 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 possible total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact and can cause each other, making it hard to determine the root cause of a crisis from observable factors. We propose a robust sequence of intervention.

JEL-codes: G2 E5 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fin, nep-mac and nep-rmg
Date: 2003-11
Note: CF IFM
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Related works:
Working Paper: Liquidity Shortages and Banking Crises (2002)
Journal Article: Liquidity Shortages and Banking Crises (2005)
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