Raghuram G. Rajan

Douglas W. Diamond

"We show in this paper that bank failures can be contagious. Unlike earlier work where contagion stems from depositor panics or ex ante contractual links between banks, we argue 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 possible total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact and can cause each other, making it hard to determine the root cause of a crisis from observable factors. We propose a robust sequence of intervention"--NBER website

Liquidity Shortages and Banking Crises

The National Bureau of Economic Research, Inc. (NBER) presents an abstract of the June 2000 working paper entitled "Banks, Short Term Debt and Financial Crises: Theory, Policy Implications and Applications," written by Douglas W. Diamond and Raghuram G. Rajan. The full text of the paper may be purchased online. This paper argues that while the empirical association between a financial institution's short-term borrowing and susceptibility to crises may exist, the direction of causality is often the opposite to the one traditionally suggested by commentators.

Theory, Policy Implications and Applications

Banks, Short Term Debt and Financial Crises

Robert J. Shiller

John Y. Campbell

Frederic S. Mishkin

Kenneth R. French

René M. Stulz

Jeremy C. Stein

Matthew J. Slaughter

Hyun Song Shin

David S. Scharfstein

Anil K. Kashyap

Darrell Duffie

Martin N. Baily

John H. Cochrane

In the fall of 2008, fifteen of the world's leading economists--representing the broadest spectrum of economic opinion--gathered at New Hampshire's Squam Lake. Their goal: the mapping of a long-term plan for financial regulation reform. The Squam Lake Report distills the wealth of insights from the ongoing collaboration that began at these meetings and provides a revelatory, unified, and coherent voice for fixing our troubled and damaged financial markets. As an alternative to the patchwork solutions and ideologically charged proposals that have dominated other discussions, the Squam Lake group sets forth a clear nonpartisan plan of action to transform the regulation of financial markets--not just for the current climate--but for generations to come. Arguing that there has been a conflict between financial institutions and society, these diverse experts present sound and transparent prescriptions to reduce this divide. They look at the critical holes in the existing regulatory framework for handling complex financial institutions, retirement savings, and credit default swaps. They offer ideas for new financial instruments designed to recapitalize banks without burdening taxpayers. To lower the risk that large banks will fail, the authors call for higher capital requirements as well as a systemic regulator who is part of the central bank. They collectively analyze where the financial system has failed, and how these weak points should be overhauled. Combining an immense depth of academic, private sector, and public policy experience, The Squam Lake Report contains urgent recommendations that will positively influence everyone's financial well-being--all who care about the world's economic health need to pay attention.

Fixing the Financial System

The Squam Lake Report

Douglas W. Diamond

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