Working Paper: NBER ID: w7431
Authors: Douglas W. Diamond; Raghuram G. Rajan
Abstract: Banks can create liquidity because their deposits are fragile and prone to runs. Increased uncertainty can make deposits excessively fragile in which case there is a role for outside bank capital. Greater bank capital reduces liquidity creation by the bank but enables the bank to survive more often and avoid distress. A more subtle effect is that banks with different amounts of capital extract different amounts of repayment from borrowers. The optimal bank capital structure trades off the effects of bank capital on liquidity creation, the expected costs of bank distress, and the ease of forcing borrower repayment. The model can account for phenomena such as the decline in average bank capital in the United States over the last two centuries. It points to overlooked side-effects of policies such as regulatory capital requirements and deposit insurance.
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 |
|---|---|
| increased uncertainty (D89) | excessive fragility of deposits (F65) |
| greater bank capital (G28) | reduced liquidity creation (E51) |
| greater bank capital (G28) | avoid distress (H84) |
| capital structure (G32) | borrower repayment dynamics (G51) |
| capital structure (G32) | extraction of repayment from borrowers (G51) |
| optimal capital structure (G32) | trade-off between liquidity creation, expected costs of distress, and borrower repayment facilitation (G33) |