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A Theory of Bank Capital
Author(s) -
Diamond Douglas W.,
Rajan Raghuram G.
Publication year - 2000
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/0022-1082.00296
Subject(s) - market liquidity , capital requirement , capital (architecture) , monetary economics , bank run , deposit insurance , business , capital adequacy ratio , financial capital , financial system , bank regulation , economic capital , economics , microeconomics , market economy , human capital , archaeology , history , incentive , profit (economics)
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.