Bank Liquidity Requirements and Financial Stability

Douglas Diamond, University of Chicago

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Douglas Diamond, Merton H. Miller Distinguished Service Professor of Finance at the University of Chicago Booth School of Business, spoke at the Australasian Finance and Banking Conference on the goal of, and need for, liquidity regulation. Professor Diamond pointed to the flaws in simply applying constant, high liquidity requirements to financial institutions: predominantly highlighting the fact that banks require more or less liquidity depending on the circumstances.  Rather than maintaining the widespread belief that liquidity requirements must be set to such a level that the bank would be covered in times of stress, Professor Diamond proposed that there should be a minimum level liquidity requirement that provides banks with the incentive to hold a greater amount on their own accord. The benefits of such an approach, Professor Diamond proposed, would include that the financial institutions themselves possess the information to determine how much liquidity they require at the time, and the extra individually-determined liquidity in excess of the mandatory minimum, would help to deter bank runs from occurring. Professor Diamond pointed to a newer model aimed at setting a lower liquidity requirement that ultimately ensures that banks hold enough liquidity to deter runs in a given situation.