TY  - JOUR
AU  - Diamond,Douglas W.
AU  - Rajan,Raghuram
TI  - Illiquid Banks, Financial Stability, and Interest Rate Policy
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 16994
PY  - 2011
Y2  - April 2011
DO  - 10.3386/w16994
UR  - http://www.nber.org/papers/w16994
L1  - http://www.nber.org/papers/w16994.pdf
N1  - Author contact info:
Douglas W. Diamond
Booth School of Business
University of Chicago
5807 S Woodlawn Avenue
Chicago, IL 60637
Tel: 773/702-7283
E-Mail: douglas.diamond@chicagobooth.edu

Raghuram Rajan
Booth School of Business
University of Chicago
5807 South Woodlawn Avenue
Chicago, IL 60637
Tel: 773/702-4437
Fax: 773/702-0458
E-Mail: raghuram.rajan@ChicagoBooth.edu
AB  - 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.
ER  -