Diamond and Rajan's paper "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking" examines the role of banks in managing liquidity risk and creating liquidity in the financial system. The authors argue that banks are essential in resolving liquidity problems that arise in direct lending. Banks enable depositors to withdraw at low cost and buffer firms from the liquidity needs of their investors. The paper shows that banks have to have a fragile capital structure, subject to bank runs, in order to perform these functions. This fragility is not an aberration to be regulated away, but rather a rational feature of the banking system. The paper also shows that the combination of bank activities is risky, and that it makes sense to legislate the separation of banking activities. However, the authors argue that there is logic, hitherto unnoticed, for the bank's choice of activities. Financial fragility is a desirable characteristic of banks. The paper presents a framework in which entrepreneurs and potential financiers interact. The economy lasts for two periods and three dates. Each entrepreneur has a project that lasts for two periods and requires an investment of up to $1 at date 0. The project produces a riskless cash flow of C_t at date t. The entrepreneur can raise money by issuing contracts, which specify repayments P_t that the borrower is required to make at date t. The relationship lender develops specific skills in identifying the liquidation value of the assets. She can identify the second best use of the asset more precisely than anyone else. This allows her to extract more from the entrepreneur. The paper also discusses the limitations on the willingness of financiers to lend. First, at any date an agent can commit to work on the specific venture only for that date. This implies that after borrowing and investing at date 0, the entrepreneur could threaten to quit before cash flows are due to be produced at date 1 unless the terms of financing are renegotiated. The second limitation is that with probability θ at date 1, the relationship lender could get a liquidity shock, which makes her impatient. The shock increases her personal rate of time preference, making one unit of date-1 goods worth R units of date-2 goods to her. The paper shows that the entrepreneur's first priority in the contract he offers is to minimize the probability of liquidation, following which he will focus on reducing the illiquidity premium by ensuring the contract pays the maximum possible to the lender if she turns out to be impatient at date 1. The paper also discusses the consequences of illiquid loans and the sources of illiquidity. The authors argue that the illiquidity premium arises because the impatient relationship lender will realize less from the loan at date 1 than the present value of payoffs if she held the loan to maturity and discounted at the market interest rate. Relationship loans can be an unbreakable bundle of state contingent claims (in states where lender type differs). Thus, aDiamond and Rajan's paper "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking" examines the role of banks in managing liquidity risk and creating liquidity in the financial system. The authors argue that banks are essential in resolving liquidity problems that arise in direct lending. Banks enable depositors to withdraw at low cost and buffer firms from the liquidity needs of their investors. The paper shows that banks have to have a fragile capital structure, subject to bank runs, in order to perform these functions. This fragility is not an aberration to be regulated away, but rather a rational feature of the banking system. The paper also shows that the combination of bank activities is risky, and that it makes sense to legislate the separation of banking activities. However, the authors argue that there is logic, hitherto unnoticed, for the bank's choice of activities. Financial fragility is a desirable characteristic of banks. The paper presents a framework in which entrepreneurs and potential financiers interact. The economy lasts for two periods and three dates. Each entrepreneur has a project that lasts for two periods and requires an investment of up to $1 at date 0. The project produces a riskless cash flow of C_t at date t. The entrepreneur can raise money by issuing contracts, which specify repayments P_t that the borrower is required to make at date t. The relationship lender develops specific skills in identifying the liquidation value of the assets. She can identify the second best use of the asset more precisely than anyone else. This allows her to extract more from the entrepreneur. The paper also discusses the limitations on the willingness of financiers to lend. First, at any date an agent can commit to work on the specific venture only for that date. This implies that after borrowing and investing at date 0, the entrepreneur could threaten to quit before cash flows are due to be produced at date 1 unless the terms of financing are renegotiated. The second limitation is that with probability θ at date 1, the relationship lender could get a liquidity shock, which makes her impatient. The shock increases her personal rate of time preference, making one unit of date-1 goods worth R units of date-2 goods to her. The paper shows that the entrepreneur's first priority in the contract he offers is to minimize the probability of liquidation, following which he will focus on reducing the illiquidity premium by ensuring the contract pays the maximum possible to the lender if she turns out to be impatient at date 1. The paper also discusses the consequences of illiquid loans and the sources of illiquidity. The authors argue that the illiquidity premium arises because the impatient relationship lender will realize less from the loan at date 1 than the present value of payoffs if she held the loan to maturity and discounted at the market interest rate. Relationship loans can be an unbreakable bundle of state contingent claims (in states where lender type differs). Thus, a