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

By Douglas W. Diamond, R. Rajan. Journal of Political Economy, 2001

2,138 citations recorded by the source corpus.

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.

Subfields: Accounting, Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/1807f9e9258f77ef5bcf65061314f60676031e5a

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Citations in the corpus

Toward a Run-Free Financial System (2014, background): “Diamond and Rajan (2001) propose a theory of the need for run-prone liabilities that is diametrically opposite to the Gorton-Metrick view of short term debt as information-insensitive and hence money-like.”
Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007-09 (2010, neutral): “Maintaining large capital buffers is costly from an economic standpoint since debt, especially if short-term and demandable, has market discipline role that cannot be served by the relatively passive nature of equity financing (Calomiris and Kahn, 1991; Diamond and Rajan, 2001).”
Bank Capital and Lending Relationships: Bank Capital and Lending Relationships (2017, neutral): “However, theories in which bank fragility induces monitoring (Calomiris and Kahn 1991) and liquidity creation (Diamond and Rajan 2001), and theories of moral hazard and risk-shifting (Jensen and Meckling 1976; Admati et al. 2013) lead to the opposite sorting, with bank-dependent firms borrowing…”
Bank Capital and Financial Stability: An Economic Trade-Off or a Faustian Bargain? (2014, background): “The argument that higher capital in bankingmay involve significant costs has been endorsed by some in the literature (e.g., Diamond & Rajan 2001), but others strongly disagree (e.g., Admati et al. 2013 andAdmati&Hellwig 2013, who advocate substantially higher capital requirements in banking and…”
The Role of Interbank Markets in Monetary Policy: A Model with Rationing (2008, methodology): “Our model allows for a discussion of the composition effect.(18) As it is, our model does not distinguish between different maturities in the portfolio of loans, as there is a unique representative project facing a unique representative bank.”
Competition and Stability in Banking (2016, neutral): “The demand deposit contract, redeemable at par, creates a coordination problem for investors, which allows bankers to not extort rents on their abilities to collect illiquid loans (Diamond and Rajan 2001) or disciplines bank managers subject to a moral 30% 35% 40% 45% 50% 55% 60%”
Pro-Cyclical Capital Regulation and Lending (2016, neutral): “We address these issues by examining changes in bank lending in Germany around 1See Peltzman (1970), Koehn and Santomero (1980), Kim and Santomero (1988), Blum and Hellwig (1995), Diamond and Rajan (2000, 2001), Morrison and White (2005), or Acharya (2009).”
New Evidence on the Lending Channel (2006, neutral): “Equation (1) describes the empirical model actually estimated: ∆ln(loans)t α0 α1∆ln(deposits)t βXt 1 γXt 1∆ln(deposits)t Σtηt .”
Optimal Supervisory Policies and Depositor-Preference Laws (2001, neutral): “(3)Calomiris and Kahn (1991), Flannery (1994) and Diamond and Rajan (1998) explain the advantages of combining these two functions in a single intermediary. (4)Flannery (1996) and Freixas, Parigi and Rochet (2000) provide a rationale for a lender of last resort based on interbank market failures ari”
Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive (2013, neutral): “46 See also Diamond and Rajan (2001), where demandable debt, with the threat of a run, serves to make the banker tougher in his negotiations with the bank’s own borrowers.”