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

55 Pages Posted: 25 Jul 2000  

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: December 1999

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.

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: https://ssrn.com/abstract=227588

Douglas W. Diamond (Contact Author)

University of Chicago - Booth School of Business ( email )

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Raghuram G. Rajan

University of Chicago - Booth School of Business ( email )

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773-702-0458 (Fax)

International Monetary Fund (IMF) ( email )

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National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States
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773-702-0458 (Fax)

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