Illiquid banks, financial stability, and interest rate policy, Working Paper 16994, National Bureau of Economic Research

Banks finance illiquid assets with demandable deposits, which disci-pline bankers but expose them to damaging runs. Authorities may not want to stand by and watch banks collapse. However, uncon-strained direct bailouts undermine the disciplinary role of deposits. Moreover, competition forces banks to promise depositors more, in-creasing intervention and making the system worse off. By contrast, constrained central bank 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 should raise rates in normal times to offset distortions from reducing rates in adverse times. Should central banks alter interest rates to deal with episodes of illiq-uidity and financial fragility? For instance, Greenspan (2002, 5) has argued that while the Federal Reserve cannot recognize or prevent asse