A Theory of Bank Capital

Authors

  • Douglas W. Diamond,

  • Raghuram G. Rajan

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    • Both authors are from the Graduate School of Business, University of Chicago and the NBER. We are grateful for financial support from the National Science Foundation and the Center for Research in Security Prices. We received helpful comments from Patrick Bolton, Michael Brennan, V. V. Chari, Gary Gorton, and Andrew Winton. Heitor Almeida provided invaluable research assistance.

Abstract

Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creating a role for outside bank capital. Greater bank capital reduces the probability of financial distress but also reduces liquidity creation. The quantity of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, costs of bank distress, and the ability to force borrower repayment. The model explains the decline in bank capital over the last two centuries. It identifies overlooked consequences of having regulatory capital requirements and deposit insurance.

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