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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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Bibliographic Info

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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Publication status: published as Douglas W. Diamond & Raghuram G. Rajan, 2012. "Illiquid Banks, Financial Stability, and Interest Rate Policy," Journal of Political Economy, University of Chicago Press, vol. 120(3), pages 552 - 591.
Handle: RePEc:nbr:nberwo:16994

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  1. Xavier Freixas & Antoine Martin & David Skeie, 2010. "Bank liquidity, interbank markets and monetary policy," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 1202, Department of Economics and Business, Universitat Pompeu Fabra.
  2. Tobias Adrian & Hyun Song Shin, 2008. "Financial intermediaries, financial stability, and monetary policy," Staff Reports, Federal Reserve Bank of New York 346, Federal Reserve Bank of New York.
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Cited by:
  1. Ryo Kato & Takayuki Tsuruga, 2011. "Bank Overleverage and Macroeconomic Fragility," IMES Discussion Paper Series 11-E-15, Institute for Monetary and Economic Studies, Bank of Japan.
  2. Agur, Itai & Demertzis, Maria, 2013. "“Leaning against the wind” and the timing of monetary policy," Journal of International Money and Finance, Elsevier, Elsevier, vol. 35(C), pages 179-194.
  3. Jin Cao & Gerhard Illing, 2012. ""Interest Rate Trap", or: Why Does the Central Bank Keep the Policy Rate too Low for too Long Time?," CESifo Working Paper Series 3794, CESifo Group Munich.
  4. Giovanni Dell'Ariccia, 2012. "Property Prices and Bank Risk-taking," RBA Annual Conference Volume, Reserve Bank of Australia, in: Alexandra Heath & Frank Packer & Callan Windsor (ed.), Property Markets and Financial Stability Reserve Bank of Australia.
  5. Aboura, Sofiane & Lépinette-Denis, Emmanuel, 2014. "An Alternative Model to Basel Regulation," Economics Papers from University Paris Dauphine, Paris Dauphine University 123456789/13633, Paris Dauphine University.
  6. Angela Maddalonia & Jose-Luis Peydro, 2013. "Monetary Policy, macroprudential Policy, and Banking Stability: Evidence from the Euro Area," International Journal of Central Banking, International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 121-169, March.
  7. Karl Aiginger, 2011. "Why Growth Performance Differed across Countries in the Recent Crisis: the Impact of Pre-crisis Conditions," Review of Economics & Finance, Better Advances Press, Canada, vol. 1, pages 35-52, August.
  8. Pierre-Richard Agénor & Luiz A. Pereira da Silva, 2013. "Inflation Targeting and Financial Stability: A Perspective from the Developing World," Working Papers Series, Central Bank of Brazil, Research Department 324, Central Bank of Brazil, Research Department.

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