Optimal Banking Arrangements: Liquidity Creation Without Financial Fragility

Maxi Günnewig () and Yuliyan Mitkov ()

CRC TR 224 Discussion Paper Series from University of Bonn and University of Mannheim, Germany

Abstract: Diamond and Rajan (2000, 2001) argue that banks create liquidity by issuing deposits to fund difficult, illiquid firms that otherwise cannot obtain funding. Since deposits may lead to bank runs, this resulting financial fragility is essential for liquidity creation. We revisit the Diamond-Rajan model of financial intermediation and show that a bank with an optimal financing structure is not subject to runs. Our contract rests on three simple notions. First, each bank creditor has the right to demand repayment at every instant. Second, the repayment is given by the value of a pre- specified fraction of the bank’s assets. Third, some creditors are more senior than others: their repayment demands are prioritized. In contrast to Diamond and Rajan, we find that financial fragility is detrimental to liquidity creation.

Keywords: Liquidity; banking; financial fragility; optimal contracts; collateral. (search for similar items in EconPapers)
JEL-codes: G21 (search for similar items in EconPapers)
Pages: 40
Date: 2024-11
New Economics Papers: this item is included in nep-ban, nep-fdg and nep-mon
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