American Economic Review Vol. 91 No. 2 2001
Banks and Liquidity
Abstract
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).
- DOI
- 10.1257/aer.91.2.422
- Volume
- 91
- Issue
- 2
- Pages
- 422-425
- Language
- en
- Sources
- bibtex:phds-export.bib crossref openalex