Liquidity Transformation and Fragility in the US Banking Sector

57 Pages Posted: 25 Feb 2021

See all articles by Rahul Vashishtha

Rahul Vashishtha

Duke University

Qi Chen

Duke University - Fuqua School of Business

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department

Zeqiong Huang

Yale School of Management

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Date Written: February 22, 2021

Abstract

We provide the first large-scale evidence that liquidity transformation by banks creates fragility, as uninsured depositors face an incentive to withdraw money before others (a so-called panic run). Such fragility manifests itself in stronger sensitivity of deposit flows to bank performance. The fragility is stronger when the aggregate conditions in the banking system deteriorate. Multiple analyses show that depositors’ motives are not driven purely by fundamentals, but reflect an element of panic. We analyze the tradeoff banks face when setting their level of liquidity transformation, and show how they use deposit insurance to mitigate some of its negative effects.

Keywords: Liquidity transformation, Bank runs, Strategic complementarity

JEL Classification: G21, M40

Suggested Citation

Vashishtha, Rahul and Chen, Qi and Goldstein, Itay and Huang, Zeqiong, Liquidity Transformation and Fragility in the US Banking Sector (February 22, 2021). Available at SSRN: https://ssrn.com/abstract=3792252 or http://dx.doi.org/10.2139/ssrn.3792252

Rahul Vashishtha

Duke University ( email )

Durham, NC 27708-0204
United States
919-660-7755 (Phone)
91-660-7971 (Fax)

Qi Chen

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
(919) 660-7753 (Phone)

Itay Goldstein (Contact Author)

University of Pennsylvania - The Wharton School - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-746-0499 (Phone)

Zeqiong Huang

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

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