Template-Type: ReDIF-Paper 1.0
Title: Optimal Banking Arrangements:
Liquidity Creation Without Financial Fragility
Author-Name: Maxi Günnewig
Author-Email: mguennewig@uni-bonn.de
Author-Name: Yuliyan Mitkov
Author-Email: ymitkov@uni-bonn.de
Classification-JEL: G21
Keywords: Liquidity, banking, financial fragility, optimal contracts, collateral.

Abstract: Diamond and Rajan (2000, 2001) argue that banks create liquidity by issuing deposits to fund difficult, illiquid firms that otherwise cannot obtain
funding. Since deposits may lead to bank runs, this resulting financial fragility is essential for liquidity creation. We revisit the Diamond-Rajan model
of financial intermediation and show that a bank with an optimal financing structure is not subject to runs. Our contract rests on three simple
notions. First, each bank creditor has the right to demand repayment at every instant. Second, the repayment is given by the value of a pre-
specified fraction of the bank’s assets. Third, some creditors are more senior than others: their repayment demands are prioritized. In contrast to
Diamond and Rajan, we find that financial fragility is detrimental to liquidity creation.


Note: 
Length: 40
Creation-Date: 2024-11
Revision-Date:
File-URL: https://www.crctr224.de/research/discussion-papers/archive/dp605
File-Format: application/pdf
Handle: RePEc:bon:boncrc:CRCTR224_2024_605