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Liquidity Shortages and Banking Crises

Authors

  • DOUGLAS W. DIAMOND,

  • RAGHURAM G. RAJAN

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    • Diamond and Rajan are from the University of Chicago and NBER, and University of Chicago, IMF, and NBER, respectively, we thank John Cochrane, Isabel Gödde, Gary Gorton, Nobuhiro Kiyotaki, and an anonymous referee for very helpful comments on an earlier draft; Steve Ross and participants at the NBER Economic Fluctuations and Growth meetings for helpful suggestions; and Efram Benmelech for great research assistance. We are grateful for financial support from the National Science Foundation and the Center for Research in Security Prices at the University of Chicago. Rajan also thanks the George J. Stigler Center for the Study of the Economy and the State for financial support.

ABSTRACT

We show in this article that bank failures can be contagious. Unlike earlier work where contagion stems from depositor panics or contractual links between banks, we argue that 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 total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity and solvency problems interact and can cause each other, making it hard to determine the cause of a crisis. We propose a robust sequence of intervention.

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