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Illiquid Banks, Financial Stability, and Interest Rate Policy

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  • Douglas W. Diamond
  • Raghuram Rajan

Abstract

Do low interest rates alleviate banking fragility? Banks finance illiquid assets with demandable deposits, which discipline bankers but expose them to damaging runs. Authorities may choose to bail out banks being run. Unconstrained 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 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 can reduce financial fragility by raising rates in normal times to offset their propensity to reduce rates in adverse times.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16994.

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Date of creation: Apr 2011
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Handle: RePEc:nbr:nberwo:16994

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  1. Tobias Adrian & Hyun Song Shin, 2008. "Financial intermediaries, financial stability, and monetary policy," Staff Reports 346, Federal Reserve Bank of New York.
  2. Xavier Freixas & Antoine Martin & David Skeie, 2010. "Bank liquidity, interbank markets and monetary policy," Economics Working Papers 1202, Department of Economics and Business, Universitat Pompeu Fabra.
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