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A Theory of Bank Capital

Douglas W. Diamond and Raghuram G. Rajan
The Journal of Finance
Vol. 55, No. 6 (Dec., 2000), pp. 2431-2465
Published by: Wiley for the American Finance Association
Stable URL: http://www.jstor.org/stable/222390
Page Count: 35
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A Theory of Bank Capital
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Abstract

Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creating a role for outside bank capital. Greater bank capital reduces the probability of financial distress but also reduces liquidity creation. The quantity of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, costs of bank distress, and the ability to force borrower repayment. The model explains the decline in bank capital over the last two centuries. It identifies overlooked consequences of having regulatory capital requirements and deposit insurance.

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