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| Diamond, Douglas W. and Raghuram G. Rajan, "Liquidity Risk, Liquidity Creation and Financial Fragility: A theory of banking", Journal of Political Economy, Vol. 109, No. 2, (April 2001), pp. 287-327. Abstract: Loans are illiquid when a lender needs relationship specific skills to collect them. If the relationship lender may need funds before the loan matures, she may demand to liquidate early, or require a return premium, when she lends directly. Borrowers also risk losing funding. The costs of illiquidity are avoided if the relationship lender is a bank with a fragile capital structure, subject to runs. Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors' liquidity needs. Stabilization policies, such as capital requirements, narrow banking, and suspension of convertibility, may reduce liquidity creation. Books Referenced in this Paper: (what is this?)
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