Banking fragility and liquidity creation: options as a substitute for deposits
- 477 Downloads
Diamond and Rajan (J Finance 55:2431–2465, 2000; Am Econ Rev Papers Proc 91:422–425, 2001a; Carnegie–Rochester Conf Series Public Policy 54:37–71, 2001b; J Pol Econ 109:287–327, 2001c) have shown in a series of papers that it is precisely the fragility of their capital structure which allows banks to create liquidity. This is because the threat of runs by depositors forces bankers to extract full repayment on otherwise illiquid assets. This result has important implications for financial regulation, such as for capital requirements and deposit insurance. This note shows that put options held by bank owners dominate deposit financing in that they also discipline bankers but do not give rise to inefficient runs. Fragility is thus not necessary for liquidity creation in the Diamond–Rajan framework.
KeywordsBanking fragility Liquidity creation Put options
JEL ClassificationG21 G28
This article is distributed under the terms of the Creative Commons Attribution Noncommercial License which permits any noncommercial use, distribution, and reproduction in any medium, provided the original author(s) and source are credited.
- Arping, S.: Credit protection and lending relationships. Mimeo. University of Amsterdam (2005)Google Scholar
- Bartram, S.M., Brown, G.W., Hund, J.E.: Estimating systemic risk in the international financial system. Working paper no. 2005-12, FDIC Center for Financial Research (2005)Google Scholar
- Chiesa, G.: Risk transfer, lending capacity and real investment activity. Mimeo. University of Bologna (2005)Google Scholar
- Diamond, D., Rajan, R.: Banks and liquidity. Am Econ Rev Papers Proc 91, 422–425 (2001a)Google Scholar