NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

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

Douglas W. Diamond, Raghuram G. Rajan

NBER Working Paper No. 7430
Issued in December 1999
NBER Program(s):Corporate Finance, Monetary Economics

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.

download in pdf format
   (296 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w7430

Published:

Users who downloaded this paper also downloaded* these:
Brunnermeier w14612 Deciphering the Liquidity and Credit Crunch 2007-08
Brunnermeier and Pedersen w12939 Market Liquidity and Funding Liquidity
Calomiris and Gorton The Origins of Banking Panics: Models, Facts, and Bank Regulation
Holmstrom and Tirole w5817 Private and Public Supply of Liquidity
Bernanke and Gertler w2318 Financial Fragility and Economic Performance
 
Publications
Activities
Meetings
NBER Videos
Themes
Data
People
About

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us