More Balanced Monetary Policy Needed to Avoid Bank Illiquidity

Published on March 19, 2009

If central banks took the politically difficult step of regularly raising interest rates during times of high solvency and unused capacity rather than only relying on lowering rates during potential fragility, then bank stability and liquidity would be positively affected, suggests a study by Douglas Diamond, Merton H. Miller Distinguished Service Professor of Finance and Raghu Rajan, Eric J. Gleacher Distinguished Service Professor of Finance.

Moving the interest rate around to affect financial institutions “looks a lot less interventionist than, say, nationalizing banks or things like that,” Diamond said in a presentation March 19 at the Harper Center. The presentation was part of the workshop titled "Liquidity, Solvency and Bubbles in Financial Markets” sponsored by the Milton Friedman Institute for Research in Economics.

Pushing down rates should they get too high poses the advantage of stopping a run on banks and recapitalizing them to make them more liquid. Knowing ahead of time that such a practice is likely to occur, however, could encourage banks to boost leverage and fund more illiquid projects, said the 2008 report, “Illiquidity and Interest Rate Policy.”

“This could change the level of leverage banks choose upfront,” Diamond said.

If the idea is to give banks an incentive to avoid illiquid assets, “it needs to be an interest rate smoothing policy,” Diamond said. “If you’re going to push interest rates down below the natural rate of interest in these high, liquidity-short environments, you have to also push them up in the more benign environments.”

From about 2002 to 2006, the Fed kept interest rates low even though banks were not low on capital or facing potential fragility, he said. Some say it may have been this monetary policy of the Alan Greenspan-led Federal Reserve Bank — others say it may have been the global savings glut providing ample supply of capital to the United States — that made it “unavoidable that rates went down,” Diamond said.

Whichever the case, “the very low interest rate period there, 2002 to 2006, may have contributed to providing incentives for financial intermediaries to set up lots of illiquid structures that caused trouble today,” Diamond said. He was referring to structured investment vehicles.

While the authors didn’t intend for the study to serve as a model for the current economic crisis, Diamond said, it “does actually fit pretty well with what happened last fall.”

The two professors based their model on the given that financial institutions are financed exclusively with short-term debt. The model showed that if you knew for sure the short-term interest rates were going to be persistently low, you’d choose to use short-term debt to finance long-term illiquid assets.

Capital requirements may be needed as well as interest rate interventions, he said.

“One thing you can show here is that a capital requirement combined with an intervention can be superior to no intervention at all,” Diamond said. “And intervention without a capital requirement, depending on how low you push the interest rates, how much welfare weight the monetary authority puts on entrepreneurs, can actually make things worse off than no intervention.”

                                                                                                                            Mary Sue Penn

 Read a summary of Diamond’s and Rajan’s paper by Asani Sarkar of the Federal Reserve Bank of New York