Major technological, regulatory, and institutional changes have made finance more widely available in recent years. The ability of institutions to price a variety of exotic instruments, and to assess and spread risks, has increased. More data on potential borrowers is now available, and it is also more timely. Improvements in accounting disclosure have resulted in greater borrower transparency. Deregulation has resulted in greater competition and better prices in markets. Finally, regulatory barriers protecting the turf of different kinds of institutions have come down, resulting in the emergence of new institutional forms. These changes amount to a bona fide financial revolution. In this article, we focus on the impact the revolution has had on the way firms are (or should be) organized and managed, and on the policy consequences. To do this, we first need to understand what firms are and what drives their organizational structure. A caveat is in order at the outset. Finance is not the only force transforming the nature of firms in the last two decades; deregulation and technological change have also played big roles. These have been explored elsewhere (see e.g., Rajan and Zingales, 2000); hence, our focus. I. Critical Resource Theory

Banks perform valuable activities on either side of their balance sheets. On the asset side, they make loans to difficult, illiquid borrowers. On the liability side, they provide liquidity on demand to depositors. But there seems to be a fundamental incompatibility between the two activities: the demands for liquidity by depositors may arrive at an inconvenient time and force the fire-sale liquidation of illiquid assets. Furthermore, because depositors are served in sequence, the prospect of fire sales may precipitate self-fulfilling runs that further jeopardize bank activities. Is this an aberration, stemming from historical accident, and enshrined by deposit insurance? Or is there logic, hitherto unnoticed, for the bank’s choice of activities? Our recent work suggests that the answer to the latter question is yes. In order to describe why a bank’s fragile capital structure allows it to create liquidity and to explain why bank loans are illiquid, we present a simple example based on Diamond and Rajan (2001a).

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.