Liquidity Transformation and Fragility in the US Banking Sector

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