Liquidity Transformation and Fragility in the Us Banking Sector

Abstract

One of the key roles of banks is liquidity transformation, which is also thought to create fragility, as uninsured depositors face an incentive to withdraw money before others (a so-called panic run). Despite large amount of theoretical work, there has not been much empirical evidence establishing this mechanism. In this paper, we provide the first large-scale evidence on this mechanism. Banks that perform more liquidity transformation exhibit higher fragility, manifested by stronger sensitivity of uninsured deposit flows to bank performance and greater levels of uninsured deposit outflows when performance is poor. We also explore the effects of deposit insurance and systemic risk.