Working Paper: NBER ID: w16994
Authors: Douglas W. Diamond; Raghuram Rajan
Abstract: 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.
Keywords: Banks; Financial Stability; Interest Rate Policy
JEL Codes: E4; E5; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central bank intervention to alleviate financial stress by lending to markets to reduce the short term real interest rate (E52) | improved financial stability (G28) |
| expectations of low real interest rates (E43) | increased future need for low rates (E43) |
| a willingness to recapitalize banks directly at times of stress (G28) | undermine the discipline induced by rigid private capital structures (G32) |
| intervention (D74) | undermine private commitment and make the system worse off (D73) |
| undirected interest rate intervention where the central bank lends to any solvent bank that needs funds (E52) | preserves the commitment induced by private contracts (D86) |
| the central bank may have to commit to push the interest rate above the natural equilibrium rate in states where liquidity needs are low (E52) | counteract the effects of previous interventions (C90) |
| lowering interest rates (E43) | increased leverage and fragility in the banking system (F65) |