Liquidity Shortages and Banking Crises

44 Pages Posted: 8 Jan 2012 Last revised: 8 Jan 2022

See all articles by Douglas W. Diamond

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)

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Date Written: November 2003

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.

Suggested Citation

Diamond, Douglas W. and Rajan, Raghuram G., Liquidity Shortages and Banking Crises (November 2003). NBER Working Paper No. w10071, Available at SSRN: https://ssrn.com/abstract=1981555

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Raghuram G. Rajan

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