Abstract

http://ssrn.com/abstract=227588
 
 

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


Douglas W. Diamond


University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Raghuram G. Rajan


University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)

December 1999

NBER Working Paper No. w7430

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.

Number of Pages in PDF File: 55

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Date posted: July 25, 2000  

Suggested Citation

Diamond, Douglas W. and Rajan, Raghuram G., Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking (December 1999). NBER Working Paper No. w7430. Available at SSRN: http://ssrn.com/abstract=227588

Contact Information

Douglas W. Diamond (Contact Author)
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-7283 (Phone)
HOME PAGE: http://faculty.chicagobooth.edu/douglas.diamond/

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National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Raghuram G. Rajan
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-4437 (Phone)
773-702-0458 (Fax)
International Monetary Fund (IMF) ( email )
700 19th Street NW
Washington, DC 20431
United States
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
773-702-9299 (Phone)
773-702-0458 (Fax)
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References:  30
Citations:  239
Footnotes:  13

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