Liquidity Transformation and Fragility in the U.S. Banking Sector

Abstract

Liquidity transformation, a key role of banks, is thought to increase fragility, as uninsured depositors face an incentive to withdraw money before others (a so-called panic run). Despite much theoretical work, however, there is little empirical evidence establishing this mechanism. In this paper, we provide the first large-scale evidence of this mechanism. Banks that engage in more liquidity transformation exhibit higher fragility, as captured by stronger sensitivities of uninsured deposit flows to bank performance and greater levels of uninsured deposit outflows when performance is poor. We also explore the effects of deposit insurance and systemic risk.