A Theory of Bank Capital

Douglas Diamond and Raghuram Rajan

No 7431, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Banks can create liquidity because their deposits are fragile and prone to runs. Increased uncertainty can make deposits excessively fragile in which case there is a role for outside bank capital. Greater bank capital reduces liquidity creation by the bank but enables the bank to survive more often and avoid distress. A more subtle effect is that banks with different amounts of capital extract different amounts of repayment from borrowers. The optimal bank capital structure trades off the effects of bank capital on liquidity creation, the expected costs of bank distress, and the ease of forcing borrower repayment. The model can account for phenomena such as the decline in average bank capital in the United States over the last two centuries. It points to overlooked side-effects of policies such as regulatory capital requirements and deposit insurance.

JEL-codes: G20 G21 (search for similar items in EconPapers)
Date: 1999-12
New Economics Papers: this item is included in nep-cfn
Note: CF ME
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Citations: View citations in EconPapers (18)

Published as Diamond, Douglas W. and Raghuram G. Rajan. "A Theory Of Bank Capital," Journal of Finance, 2000, v55(6,Dec), 2431-2465.

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