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 -