SOAS Research Online

Abstract

This article demonstrates that financial development in the United States has heightened the vulnerability of both sides of regional banks’ balance sheets to financial market fluctuations, drawing on the concept of financial circulation of bank deposits. It first argues that financial development provides diversified short-term investment channels for non-financial sectors to manage their liquid asset holdings. Since banks intermediate money circulation, changes in liquid asset portfolios inevitably result in sudden inflows and outflows of deposits to these banks. These deposit flows are highly clustered during specific financial phases and are subject to financial volatilities rather than local business cycles, making regional banks’ liabilities volatile with market fluctuations. Second, to mitigate increased deposit instability, regional banks hold a higher proportion of marketable securities to manage liquidity. But the mark-to-market nature of security prices further puts potential instability on the asset side of banks’ balance sheets. Extremely, the sudden volatility in the financial markets could simultaneously cause deposit flights and choke off refinancing capability, causing a bank run.