Working Paper: NBER ID: w15197
Authors: Douglas W. Diamond; Raghuram G. Rajan
Abstract: The cheapest way for banks to finance long term illiquid projects is typically to borrow short term from households. But when household needs for funds are high, interest rates will rise sharply, debtors will have to shut down illiquid projects, and in extremis, will face more damaging runs. Authorities may want to push down interest rates to maintain economic activity in the face of such illiquidity, but intervention may not always be feasible, and when feasible, could encourage banks to increase leverage or fund even more illiquid projects up front. This could make all parties worse off. Authorities may want to commit to a specific policy of interest rate intervention to restore appropriate incentives. For instance, to offset incentives for banks to make more illiquid loans, authorities may have to commit to raising rates when low, to counter the distortions created by lowering them when high. We draw implications for interest rate policy to combat illiquidity.
Keywords: illiquidity; interest rate policy; central banks; financial stability
JEL Codes: E4; E44; E5; E58; G01; G21; G38
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased consumption demand (D12) | higher real interest rates (E43) |
| higher real interest rates (E43) | termination of long-term illiquid projects (G33) |
| lowering interest rates (E43) | riskier lending practices by banks (G21) |
| riskier lending practices by banks (G21) | higher leverage and more illiquid investments (G19) |
| higher leverage and more illiquid investments (G19) | greater systemic risk (E44) |
| anticipated government bailouts (H81) | over-leveraging (G32) |
| low interest rates (E43) | competition for funds among banks (G21) |
| competition for funds among banks (G21) | increased fragility and potential runs on banks (E44) |