Banks earn profits by transforming short-term deposits into longer-term loans, but that very function creates liquidity risk that can erode returns and amplify economic distress. The classic model by Douglas Diamond at University of Chicago and Philip Dybvig at Washington University explains how maturity transformation makes banks inherently vulnerable to runs when depositors demand cash simultaneously. Regulatory and market responses to that vulnerability shape banks’ asset choices, funding costs and ultimately margins, so liquidity risk is central to the business model and to financial stability in towns and global markets alike.
Liquidity risk and profit margins
Liquidity shortages push banks to hold larger cushions of high quality liquid assets that yield less than loans, compressing net interest margin and return on equity. Research by Tobias Adrian at the Federal Reserve Bank of New York and Hyun Song Shin at the Federal Reserve Bank of New York highlights how funding strains and price-mediated feedback can force asset sales, crystallizing losses and raising funding costs. The Basel Committee on Banking Supervision at Bank for International Settlements established liquidity standards to reduce systemic vulnerability, but those standards also change the composition of bank portfolios and the economics of intermediation.
Operational and systemic impacts
When access to wholesale funding tightens, smaller regional institutions with concentrated local deposit bases feel the stress more acutely, as documented in supervisory analyses by the Federal Deposit Insurance Corporation. Anil Kashyap at University of Chicago Booth and Jeremy Stein at Harvard University show that higher liquidity buffers can constrain lending capacity, reducing credit supply to households and firms and transferring costs into the real economy. Fire sales of assets during runs depress market prices and can create cascading losses across institutions, a mechanism observed in past crises and analyzed by central bank researchers.
Territorial, cultural and human dimensions shape how liquidity risk plays out: agricultural regions with seasonal cash flows see larger swings in deposit behavior, remittance-dependent communities face rollover risk when global corridors freeze, and small businesses in tourism-dependent towns can experience acute credit squeezes when banks retrench. Policymakers balance the social cost of tighter liquidity requirements against the long-term benefit of resilience, using tools and research from international institutions and central banks to tailor responses that protect both profitability and communities.
