Liquidity, Banks, and Markets : Effects of Financial Development on Banks and the Maturity of Financial Claims

The amount of liquidity that banks offer depends on the degree of direct participation in financial markets - that is, on the liquidity of financial markets. Conversely, banks influence the amount of liquidity offered by financial markets.Financial markets and financial institutions compete to provide investors with liquidity. Diamond examines the roles of banks and markets when both are active, characterizing how development of the financial markets affects the structure of and market share of banks.Banks create liquidity by offering claims with a higher short-term return than exist without a banking system. The amount of liquidity that banks offer depends on the degree of direct participation in financial markets - that is, on the liquidity of financial markets. Conversely, banks influence the amount of liquidity offered by financial markets.As more investors participate in financial markets, allowing markets to provide more liquidity, banks shrink and banks make fewer long-term loans. Moreover, the banking sector's ability to subsidize those with immediate liquidity need is reduced.More liquid markets also lead to physical investment with longer maturity, a smaller gap between the maturity of financial assets and the maturity of physical investments. Financial assets have a shorter maturity than physical investments, but this gap approaches zero as the market approaches full liquidity.Diamond provides an analytical basis for developing short-term markets as a way to stimulate the supply of long-term finance and supports the practitioner`s view that short-term financial markets are a prerequisite for the development of viable long-term finance.This paper - a product of the Finance and Private Sector Development Division, Policy Research Department - is part of a larger effort in the department to investigate the role of long term finance in the development process