Liquidity Shortages and Banking Crises

43 Pages Posted: 2 Jan 2004

See all articles by Douglas W. Diamond

Douglas W. Diamond

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Raghuram G. Rajan

University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: August 2003

Abstract

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.

Keywords: Liquidity, Crises, Banking

JEL Classification: G2, E5

Suggested Citation

Diamond, Douglas W. and Rajan, Raghuram G., Liquidity Shortages and Banking Crises (August 2003). Available at SSRN: https://ssrn.com/abstract=461535 or http://dx.doi.org/10.2139/ssrn.461535

Douglas W. Diamond (Contact Author)

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Raghuram G. Rajan

University of Chicago - Booth School of Business ( email )

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National Bureau of Economic Research (NBER)

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