Illiquid Banks, Financial Stability, and Interest Rate Policy

By Douglas W. Diamond, R. Rajan. Journal of Political Economy, 2012

287 citations recorded by the source corpus.

Banks finance illiquid assets with demandable deposits, which discipline bankers but expose them to damaging runs. Authorities may not want to stand by and watch banks collapse. However, unconstrained direct bailouts undermine the disciplinary role of deposits. Moreover, competition forces banks to promise depositors more, increasing intervention and making the system worse off. By contrast, constrained central bank intervention to lower rates maintains private discipline, while offsetting contractual rigidity. It may still lead banks to make excessive liquidity promises. Anticipating this, central banks should raise rates in normal times to offset distortions from reducing rates in adverse times.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/30128a7897c1f8f2b777e227f1eb4bc1ee98b19a

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Citations in the corpus

Liquidity Requirements, Liquidity Choice and Financial Stability (2016, unknown): “Vives (2014) analyzes a question similar to that in Ennis and Keister (2006): what are the efficient combinations of equity capital and liquidity holdings to make a bank safe when it subject to runs based on private information about its solvency? He studies a global game where a bank can be insolve”
Corporate Governance: What’s Special About Banks? (2013, background): “For example, Diamond & Rajan (2012) show that competition forces banks to make excessive liquidity promises to finance illiquid assets.”
Hazardous Times for Monetary Policy: What Do Twenty‐Three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk‐Taking? (2014, unknown): “4Allen and Gale (2000, 2004), Allen and Rogoff (2011), Diamond and Rajan (2012), Borio and Zhu (2008), among others.”
The International Bank Lending Channel of Monetary Policy Rates and QE: Credit Supply, Reach‐for‐Yield, and Real Effects (2017, unknown): “Reinhart, Carmen, and Kenneth Rogoff 2009, This Time is Different: Eight Centuries of Financial Folly, (Princeton University Press, Princeton, NJ).”
The Euro Interbank Repo Market (2016, unknown): “This finding echoes the theoretical arguments in Freixas, Martin, and Skeie (2011) and Diamond and Rajan (2012) that the central bank should lower the interbank rate when liquidity in the interbank market is impaired.30 30This is also in line with the empirical finding of Afonso, Kovner, and Schoar…”
Real interest rates, leverage, and bank risk-taking (2014, background): “20 A growing literature focuses on funding liquidity risk of banks and the adverse liquidity spirals that such risk could generate in the event of negative shocks (see [27,19,3]) and on the role of monetary policy in altering bank fragility in the presence of liquidity risk ([2]; and [31]).”
The Economics of the Fed Put (2020, unknown): “Gilchrist and Leahy (2002) extend the model evidence of Bernanke and Gertler (1999) to study the optimal response of monetary policy to asset prices in a setting with two types of shocks: technology shocks that are phased in gradually over time and net worth shocks.”
Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops (2018, unknown): “It is then always optimal for the government to choose at date 0 the lowest value of b∗∗ 0 that satisfies equation (14).”
Global Safe Assets (2012, background): “The important economic insight is that while this additional borrowing can further fragilize the economy, as emphasized in Diamond and Rajan (2011) and BIS (2011), it also contributes to an increase in stores of value, i.e. a self-correcting mechanism.”