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Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking (2001)
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| Venue: | JOURNAL OF POLITICAL ECONOMY |
| Citations: | 317 - 32 self |
BibTeX
@MISC{Diamond01liquidityrisk,,
author = {Douglas W. Diamond and Raghuram G. Rajan},
title = {Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking},
year = {2001}
}
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Abstract
Loans are illiquid when a lender needs relationship-specific skills to collect them. Consequently, if the relationship lender needs funds before the loan matures, she may demand to liquidate early, or require a return premium, when she lends directly. Borrowers also risk losing funding. The costs of illiquidity are avoided if the relationship lender is a bank with a fragile capital structure, subject to runs. Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors’ liquidity needs. Stabilization policies, such as capital requirements, narrow banking, and suspension of convertibility, may reduce liquidity creation.
Keyphrases
liquidity creation liquidity risk financial fragility political economy illiquid asset relationship lender valuable activity self-fulfilling run illiquid borrower fire sale anonymous referee fundamental incompatibility patrick bolton fire sale liquidation helpful comment asset side inconvenient time fragile capital structure narrow banking relationship-specific skill stabilization policy liability side depositor liquidity need balance sheet capital requirement liquid demand deposit return premium
