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

51 Pages Posted: 15 Aug 1998  

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)

Multiple version iconThere are 2 versions of this paper

Date Written: July 6, 1998

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.

JEL Classification: G20, G21, E50

Suggested Citation

Diamond, Douglas W. and Rajan, Raghuram G., Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking (July 6, 1998). CRSP Working Paper No. 476. Available at SSRN: https://ssrn.com/abstract=112473 or http://dx.doi.org/10.2139/ssrn.112473

Douglas W. Diamond

University of Chicago - Booth School of Business ( email )

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HOME PAGE: http://faculty.chicagobooth.edu/douglas.diamond/

National Bureau of Economic Research (NBER)

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Raghuram G. Rajan (Contact Author)

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 )

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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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