Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking

Douglas Diamond and Raghuram Rajan

No 7430, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Both investors and borrowers are concerned about liquidity. Investors desire liquidity because they are uncertain about when they will want to eliminate their holding of a financial asset. Borrowers are concerned about liquidity because they are uncertain about their ability to continue to attract or retain funding. Because borrowers typically cannot repay investors on demand, investors will require a premium or significant control rights when they lend to borrowers directly, as compensation for the illiquidity investors will be subject to. We argue that banks can resolve these liquidity problems that arise in direct lending. Banks enable depositors to withdraw at low cost, as well as buffer firms from the liquidity needs of their investors. We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions. Far from being an aberration to be regulated away, the funding of illiquid loans by a bank with volatile demand deposits is rationalized in the context of the functions it performs. This model can be used to investigate important issues such as narrow banking and bank capital requirements.

JEL-codes: G20 G21 (search for similar items in EconPapers)
Date: 1999-12
Note: CF ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (42)

Published as Journal of Political Economy, Vol. 109, no. 2 (April 2001): 287-327
Published as Douglas W. Diamond & Raghuram G. Rajan, 1998. "Liquidity risk, liquidity creation and financial fragility: a theory of banking," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.

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Journal Article: Liquidity risk, liquidity creation and financial fragility: a theory of banking (1998)
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