NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Banks, Short Term Debt and Financial Crises: Theory, Policy Implications and Applications

Douglas W. Diamond, Raghuram G. Rajan

NBER Working Paper No. 7764
Issued in June 2000
NBER Program(s):   CF   IFM

Short-term borrowing has often been blamed for precipitating financial crises. We argue that while the empirical association between a financial institution's, or country's, short-term borrowing and susceptibility to crises may, in fact, exist, the direction of causality is often precisely the opposite to the one traditionally suggested by commentators. Institutions like banks that want to enhance their ability to provide liquidity and credit to difficult borrowers have to borrow short-term. Similarly countries that have poor disclosure rules and inadequate investor protections, have limited long-term debt capacity, and will find their borrowing becoming increasingly short-term as they finance illiquid investment. Thus it is the increasing illiquidity of the investment being financed (or the deteriorating credit quality of borrowers) that necessitates short-term financing, and causes the susceptibility to crises. In fact, once illiquid investments have been financed, rather than making the system more stable, a ban on short-term financing may precipitate a more severe crisis. Even a priori, a ban is not without adverse consequences policy makers have to trade off the costs of decreased credit creation and investment against the benefits of greater stability. A ban on short-term debt often deals with symptoms rather than underlying causes.

download in pdf format
   (139 K)

email paper

This paper is available as PDF (139 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Published: Diamond, Douglas W. & Rajan, Raghuram G., 2001. "Banks, short-term debt and financial crises: theory, policy implications and applications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 54(1), pages 37-71, June.

Users who downloaded this paper also downloaded these:
Rodrik and Velasco w7364 Short-Term Capital Flows
Diamond and Rajan w14739 The Credit Crisis: Conjectures about Causes and Remedies
Diamond and Rajan w8937 Liquidity Shortages and Banking Crises
Diamond and Rajan w7431 A Theory of Bank Capital
Diamond and Rajan w7430 Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking
 
Publications
Activities
Meetings
Data
People
About

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

Contact Us