Abstract

http://ssrn.com/abstract=466200
 
 

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Liquidity Shortages and Banking Crises


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)

May 2002

NBER Working Paper No. w8937

Abstract:     
Banks can fail either because they are insolvent or because an aggregate shortage of liquidity can render them insolvent. We show that bank failures can themselves cause liquidity shortages. The failure of some banks can then lead to a cascade of failures and a possible total meltdown of the system. Contagion here is not caused by contractual or informational links between banks but because bank failure could lead to a contraction in the common pool of liquidity. There is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact, and can each cause the other. It is therefore hard to determine the root cause of a crisis from observable factors. The practical difficulty of determining the most appropriate intervention, as well as the costs of the wrong kind of intervention (such as infusing capital when the need is for liquidity) have to be traded off against the costs of a meltdown, which can be substantial. We propose a robust sequence of intervention.

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Date posted: November 7, 2003  

Suggested Citation

Diamond, Douglas W. and Rajan, Raghuram G., Liquidity Shortages and Banking Crises (May 2002). NBER Working Paper No. w8937. Available at SSRN: http://ssrn.com/abstract=466200

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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