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Liquidity Shortages and Banking Crises
Author(s) -
DIAMOND DOUGLAS W.,
RAJAN RAGHURAM G.
Publication year - 2005
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/j.1540-6261.2005.00741.x
Subject(s) - market liquidity , solvency , economic interventionism , economic shortage , accounting liquidity , liquidity crisis , business , intervention (counseling) , bank run , monetary economics , government (linguistics) , financial system , work (physics) , liquidity risk , economics , engineering , politics , psychology , linguistics , philosophy , psychiatry , law , political science , mechanical engineering
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.