A Theory of Bank Capital

58 Pages Posted: 25 May 2006  

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

Banks can create liquidity because their deposits are fragile and prone to runs. Increased uncertainty can make deposits excessively fragile in which case there is a role for outside bank capital. Greater bank capital reduces liquidity creation by the bank but enables the bank to survive more often and avoid distress. A more subtle effect is that banks with different amounts of capital extract different amounts of repayment from borrowers. The optimal bank capital structure trades off the effects of bank capital on liquidity creation, the expected costs of bank distress, and the ease of forcing borrower repayment. The model can account for phenomena such as the decline in average bank capital in the United States over the last two centuries. It points to overlooked side-effects of policies such as regulatory capital requirements and deposit insurance.

Suggested Citation

Diamond, Douglas W. and Rajan, Raghuram G., A Theory of Bank Capital (December 1999). NBER Working Paper No. w7431. Available at SSRN: https://ssrn.com/abstract=227589

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
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773-702-0458 (Fax)

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