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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.

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. We argue that financial intermediation 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 somewhat fragile capital structure, subject to bank runs, in order to perform these functions. A number of institutional features of a bank are therefore 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.

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.

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, or the nature of disintermediation in liberalizing economies. Finally, it points to overlooked side-effects of policies such as regulatory capital requirements and deposit insurance.

Abstract:
Short-term borrowing has often been blamed for precipitating financial crises. We argue that while the empirical association between a financial institution's, or country's, short-term borrowing and susceptibility to crises may, in fact, exist, the direction of causality is often precisely the opposite to the one traditionally suggested by commentators. Institutions like banks that want to enhance their ability to provide liquidity and credit to difficult borrowers have to borrow short-term. Similarly countries that have poor disclosure rules and inadequate investor protections, have limited long-term debt capacity, and will find their borrowing becoming increasingly short-term as they finance illiquid investment. Thus it is the increasing illiquidity of the investment being financed (or the deteriorating credit quality of borrowers) that necessitates short-term financing, and causes the susceptibility to crises. In fact, once illiquid investments have been financed, rather than making the system more stable, a ban on short-term financing may precipitate a more severe crisis. Even a priori, a ban is not without adverse consequences policy makers have to trade off the costs of decreased credit creation and investment against the benefits of greater stability. A ban on short-term debt often deals with symptoms rather than underlying causes.

Abstract:
Short-term borrowing has often been blamed for precipitating financial crises. We argue that while the empirical association between a financial institution's, or country's, short-term borrowing and susceptibility to crises may, in fact, exist, the direction of causality is often precisely the opposite to the one traditionally suggested by commentators. Institutions like banks that want to enhance their ability to provide liquidity and credit to difficult borrowers have to borrow short-term. Similarly countries that have poor disclosure rules and inadequate investor protections, have limited long-term debt capacity, and will find their borrowing becoming increasingly short-term as they finance illiquid investment. Thus it is the increasing illiquidity of the investment being financed (or the deteriorating credit quality of borrowers) that necessitates short-term financing, and causes the susceptibility to crises. In fact, once illiquid investments have been financed, rather than making the system more stable, a ban on short-term financing may precipitate a more severe crisis. Even a priori, a ban is not without adverse consequences: policy makers have to trade off the costs of decreased credit creation and investment against the benefits of greater stability. A ban on short-term debt often deals with symptoms rather than underlying causes.

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.

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.

Liquidity, Crises, Banking

Abstract:
We explore the connection between money, banks, and aggregate credit. We start with a simple 'real' model without money, where banks make loans repayable in goods and depositors hold claims on the bank payable on demand in goods. Aggregate production may be delayed in the economy. If so, we show that the level of ongoing bank lending, and hence of aggregate future output, can decrease with increases in the real repayment due on deposits: ceteris paribus, the higher the amount due, the more likely there will be insufficient goods, given the delay, to pay depositors, and the more new lending has to be curtailed to make up the shortfall. Thus a temporary delay in production can be exacerbated by banks into a more permanent reduction of total output. A number of inefficiencies including bank failures can result if deposits turn out to be too high. We then introduce money in this model. We show that if demand deposits are repayable in money rather than in goods, banks can be hedged against production delays: under certain circumstances, the price level will rise with delays in production, reducing the real value of the deposits banks have to pay out. But demand deposits payable in money can expose the banks to new risks: the value of money can fluctuate for reasons other than delays in aggregate production. Because deposits are convertible into money on demand, a temporary rise in money demand immediately boosts the interest rate banks have to pay depositors, which in turn boosts the real amounts banks have to repay them. This increase in the real deposit burden can again lead to the curtailment of bank lending and even bank failures. The way to combat these contractionary effects is to infuse more money into the banking system. Our analysis thus makes transparent how changes in the supply of money can work through banks to affect real economic activity, without invoking sticky prices, reserve requirements, or deposit insurance. It also suggests how bank failures could lead to a fall in prices and a contagion of bank failures, as described by Friedman and Schwartz (1963).

Abstract:
We explore the connection between money, banks, and aggregate credit. We start with a simple 'real' model without money, where banks make loans repayable in goods and depositors hold claims on the bank payable on demand in goods. Aggregate production may be delayed in the economy. If so, we show that the level of ongoing bank lending, and hence of aggregate future output, can decrease with increases in the real repayment due on deposits: ceteris paribus, the higher the amount due, the more likely there will be insufficient goods, given the delay, to pay depositors, and the more new lending has to be curtailed to make up the shortfall. Thus a temporary delay in production can be exacerbated by banks into a more permanent reduction of total output. A number of inefficiencies including bank failures can result if deposits turn out to be too high. We then introduce money in this model. We show that if demand deposits are repayable in money rather than in goods, banks can be hedged against production delays: under certain circumstances, the price level will rise with delays in production, reducing the real value of the deposits banks have to pay out. But demand deposits payable in money can expose the banks to new risks: the value of money can fluctuate for reasons other than delays in aggregate production. Because deposits are convertible into money on demand, a temporary rise in money demand immediately boosts the interest rate banks have to pay depositors, which in turn boosts the real amounts banks have to repay them. This increase in the real deposit burden can again lead to the curtailment of bank lending and even bank failures. The way to combat these contractionary effects is to infuse more money into the banking system. Our analysis thus makes transparent how changes in the supply of money can work through banks to affect real economic activity, without invoking sticky prices, reserve requirements, or deposit insurance. It also suggests how bank failures could lead to a fall in prices and a contagion of bank failures, as described by Friedman and Schwartz (1963).

Liquidity, Money, Monetary Policy, Banking

Abstract:
What caused the financial crisis that is sweeping across the world? What keeps asset prices and lending depressed? What can be done to remedy matters? While it is too early to arrive at definite answers to these questions, it is certainly time to offer informed conjectures, and these are the focus of this paper.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
The amount of liquidity that banks offer depends on the degree of direct participation in financial markets - that is, on the liquidity of financial markets. Conversely, banks influence the amount of liquidity offered by financial markets.

Financial markets and financial institutions compete to provide investors with liquidity. Diamond examines the roles of banks and markets when both are active, characterizing how development of the financial markets affects the structure of and market share of banks.

Banks create liquidity by offering claims with a higher short-term return than exist without a banking system. The amount of liquidity that banks offer depends on the degree of direct participation in financial markets - that is, on the liquidity of financial markets. Conversely, banks influence the amount of liquidity offered by financial markets.

As more investors participate in financial markets, allowing markets to provide more liquidity, banks shrink and banks make fewer long-term loans. Moreover, the banking sector's ability to subsidize those with immediate liquidity need is reduced.

More liquid markets also lead to physical investment with longer maturity, a smaller gap between the maturity of financial assets and the maturity of physical investments. Financial assets have a shorter maturity than physical investments, but this gap approaches zero as the market approaches full liquidity.

Diamond provides an analytical basis for developing short-term markets as a way to stimulate the supply of long-term finance and supports the practitioner`s view that short-term financial markets are a prerequisite for the development of viable long-term finance.

This paper - a product of the Finance and Private Sector Development Division, Policy Research Department - is part of a larger effort in the department to investigate the role of long term finance in the development process.

Abstract:
In early 2009, the supply of credit in industrial countries appeared to decline. Could this be because bank balance sheets were “clogged� with illiquid securities? If so, why did banks not attempt to sell them? We argue that an “overhang� of impaired banks that may be forced to sell soon can reduce the current price of illiquid securities sufficiently that banks have no interest in selling. This creates high expected returns to holding cash for potential buyers and an aversion to making term loans. We discuss the implications for policies to clean up the banking system during a financial crisis.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
The cheapest way for banks to finance long term illiquid projects is typically to borrow short term from households. But when household needs for funds are high, interest rates will rise sharply, debtors will have to shut down illiquid projects, and in extremis, will face more damaging runs. Authorities may want to push down interest rates to maintain economic activity in the face of such illiquidity, but intervention may not always be feasible, and when feasible, could encourage banks to increase leverage or fund even more illiquid projects up front. This could make all parties worse off. Authorities may want to commit to a specific policy of interest rate intervention to restore appropriate incentives. For instance, to offset incentives for banks to make more illiquid loans, authorities may have to commit to raising rates when low, to counter the distortions created by lowering them when high. We draw implications for interest rate policy to combat illiquidity.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.