A Theory of Bank Capital

First Draft: January 1999 Revised: April 1999 A Theory of patois Capital Douglas W. Diamond Raghuram G. Rajan University of Chicago Abstract Banks can create liquidity because their deposits atomic number 18 fragile and prone to runs. Increased uncertainty can use up deposits excessively fragile in which case there is a role for outside rely great(p). Greater depone cracking reduces liquidity creation by the bank but enables the bank to survive to a greater extent often and avoid distress. A to a greater extent subtle effect is that banks with assorted amounts of capital extract different amounts of repayment from borrowers. The optimal bank capital building trades sour the effects of bank capital on liquidity creation, the expect be of bank distress, and the ease of forcing borrower repayment. The model can narration for phenomena such as the decline in average bank capital in the United States over the last 2 centuries, or the nature of disintermediation in liberalizing economies. Finally, it points to overlooked side-effects of policies such as regulatory capital requirements and deposit insurance. Printed on 04/21/99 Does bank capital matter, and if so, what should its level be? This question has exercised economists, regulators, and bank managers.

On the one hand, some suggest that bank capital structure is irrelevant in a generous information, complete declaration world, and to a first order of approximation, also in the more imperfect real world (see Miller (1995), for example). At the former(a) extreme, economists appeal to the large literature on the high costs of paleness issuance for industrial firms to argue that banks will squander similar difficulties in issuing long term equity (see Stein (1998), for example), and greater bank capitalization will besides be obtained at some cost. But bank assets and functions are not the same as those of industrial firms.1 How do we sleep together that they will face similar costs of issuance? And does capital really play the same role in banks as in industrial firms? What we... If you want to get a full essay, order it on our website: Ordercustompaper.com

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