Working Paper: NBER ID: w14925
Authors: Douglas W. Diamond; Raghuram G. Rajan
Abstract: Is there any need to "clean" up a banking system in the midst of a crisis, by closing or recapitalizing weak banks and taking bad assets off bank balance sheets, or can one wait till the crisis is over? We argue that an "overhang" of impaired banks that may be forced to sell assets soon can reduce the current price of illiquid assets sufficiently that weak banks have no interest in selling them. Anticipating a potential future fire sale, cash rich buyers have high expected returns to holding cash, which also reduces their incentive to lock up money in term loans. The potential for a worse fire sale than necessary, as well as the associated decline in credit origination, could make the crisis worse, which is one reason it may make sense to clean up the system even in the midst of the crisis. We discuss alternative ways of cleaning up the system, and the associated costs and benefits.
Keywords: No keywords provided
JEL Codes: E44; G01; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Impaired banks overhang (F65) | Current price of illiquid assets (G19) |
| Current price of illiquid assets (G19) | Weak banks' reluctance to sell these assets (G21) |
| Expectation of lower future prices (D84) | Current price declines (G19) |
| Cash-rich buyers' preference to hold cash (E41) | Current lending activity (G21) |
| Worse fire sale than necessary + Decline in credit origination (G33) | Exacerbation of financial crisis (F65) |