Working Paper: NBER ID: w7430
Authors: Douglas W. Diamond; Raghuram G. Rajan
Abstract: Both investors and borrowers are concerned about liquidity. Investors desire liquidity because they are uncertain about when they will want to eliminate their holding of a financial asset. Borrowers are concerned about liquidity because they are uncertain about their ability to continue to attract or retain funding. Because borrowers typically cannot repay investors on demand, investors will require a premium or significant control rights when they lend to borrowers directly, as compensation for the illiquidity investors will be subject to. We argue that banks can resolve these liquidity problems that arise in direct lending. Banks enable depositors to withdraw at low cost, as well as buffer firms from the liquidity needs of their investors. We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions. Far from being an aberration to be regulated away, the funding of illiquid loans by a bank with volatile demand deposits is rationalized in the context of the functions it performs. This model can be used to investigate important issues such as narrow banking and bank capital requirements.
Keywords: No keywords provided
JEL Codes: G20; G21; E50; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Banks' fragile capital structures (F65) | Liquidity creation (E51) |
| Banks' ability to buffer firms from liquidity needs (G21) | Financial stability (G28) |
| Financial fragility (F65) | Banks' ability to perform essential liquidity functions (G21) |
| Lender's inability to commit to future actions (G21) | Liquidity risk for lender and entrepreneur (G21) |
| Liquidity risk for lender and entrepreneur (G21) | Initial terms of loans and dynamics of interactions (E43) |
| Fragile structure (F12) | Banks' ability to lend effectively (G21) |
| Bank fragility (F65) | Overall liquidity in the economy (E51) |