Liquidity Transformation and Fragility in the US Banking Sector
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This paper provides, for the first time, large-scale evidence that liquidity transformation by banks creates fragility, as their uninsured depositors face an incentive to withdraw their money before others (a so-called panic run). Such fragility manifests itself in stronger sensitivity of deposit flows to bank performance. A deterioration in the aggregate conditions in the banking system makes the fragility within each bank stronger. We run multiple tests to show that depositors’ motives are not driven purely by fundamentals, but rather that the element of panic, leading them to think about what other depositors will do, is important in the data. 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.
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Document Object Identifier (DOI): 10.3386/w27815