Liquidity Shortages and Banking Crises
By Douglas W. Diamond, Raghu Rajan. 2003
865 citations recorded by the source corpus.
We show in this paper that bank failures can be contagious. Unlike earlier work where contagion stems from depositor panics or ex ante contractual links between banks, we argue bank failures can shrink the common pool of liquidity, creating or exacerbating aggregate liquidity shortages. This could lead to a contagion of failures and a possible total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact and can cause each other, making it hard to determine the root cause of a crisis from observable factors. We propose a robust sequence of intervention.
Subfields: Economics and Econometrics, Finance
View Paper: https://www.semanticscholar.org/paper/0afefc0eee57049d28a816d1febeb8425691d798
Citations in the corpus
- Amplification Mechanisms in Liquidity Crises (2009, neutral): “On the other hand, with banks writing down losses, their balance sheets suffered and the effects highlighted by the balance-sheet/asset-price feedback began to dominate the markets.(17) Routledge and Zin (2005) develop a micro-structure model of asset trade in which Knightian uncertainty leads to a ”
- The Interbank Market after the Financial Turmoil: Squeezing Liquidity in a 'Lemons Market' or Asking Liquidity 'on Tap' (2013, neutral): “A related strand of literature, following Allen and Gale (2000) and Diamond and Rajan (2005) analyse the effect of liquidity shocks on interbank market (Brunnermeier and Pedersen, 2009) also including the role played by central banks (Allen et al., 2009).”
- Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies (2012, neutral): “…but also increase the risk of broad systemic failure, because the failure of one segment of a large institution (e.g., the derivatives desk at AIG) can trigger a broader systemic failure through depositor panics, counter-party failures, and systemic liquidity shortages (Diamond and Rajan (2005)).”
- Liquidity hoarding and interbank market rates: The role of counterparty risk (2015, neutral): “In Diamond and Rajan (2005) , aggregate liquidity shortages lead to contagious bank failures because of an interplay of illiquidity (maturity mismatch) and insolvency.”
- Illiquid Banks, Financial Stability, and Interest Rate Policy (2012, neutral): “An important extension would be to relate future endowments to the fraction of long dated projects that are allowed to continue, as in Diamond and Rajan (2005).”
- Has Finance Made the World Riskier (2006, neutral): “…does illiquidity perpetuate the overhang of financial claims as well as uncertainty about their final resolution, a perception of too little aggregate liquidity in the system can trigger off additional demands for liquidity (Diamond and Dybvig, 1983) and create contagion (Diamond and Rajan, 2005).”
- A Theory of Bank Liquidity Requirements (2015, neutral): “6This is analogous to the mechanism in Diamond and Rajan (2005, 2011) whereby the need to raise cash, either by increasing the rate on deposits or by selling assets to a cash-constrained market, reduces the value of the bank pushing it closer to insolvency. number of depositors with equal…”