Liquidity Shortages and Banking Crises / Douglas W. Diamond, Raghuram G. Rajan.

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Diamond, Douglas W

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w10071.Publication details: Cambridge, Mass. National Bureau of Economic Research 2003.Description: 1 online resource: illustrations (black and white)Subject(s):

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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.

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Previous	nber w10069 The Origins of Spatial Interaction /	nber w1007 The Transition from School to Work: The Experiences of Blacks and Whites /	nber w10070 Money in a Theory of Banking /	nber w10071 Liquidity Shortages and Banking Crises /	nber w10072 The Alternative Minimum Tax and Effective Marginal Tax Rates /	nber w10073 Crises and Growth: A Re-Evaluation /	nber w10074 A Prism into the PPP Puzzles: The Micro-foundations of Big Mac Real Exchange Rates /	Next

November 2003.

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.