Assumption
Entrepreneurs borrow from banks to invest in long-term projects. Banks themselves borrow from risk-averse households, who receive endowments every period. Households deposit their initial endowment in banks in return for demandable deposit claims. There is no uncertainty initially about the average quality of a bank’s projects in our model, so the bank’s asset side is not the source of the problem. However, there is uncertainty about household endowments (or equivalently, incomes) over time.
Process
Firstly, households deposit their initial endowments and have an unexpectedly high need to withdraw deposits.
Anticipated prosperity, as well as current adversity, can increase current household demand for consumption goods substantially.
As households withdraw deposits to satisfy consumption needs, banks will have to call in loans to long gestation projects in order to generate the resources to pay them. The real interest rate will rise to equate the household demand for consumption goods and the supply of these goods from terminated projects.
Results
Thus greater consumption demand will lead to higher real rates and more projects being terminated, as well as lower bank net worth. This last effect is because the bank’s loans pay off only in the long run, and thus fall in value as real interest rates rise, while the bank’s liabilities, that is demandable deposits, do not fall in value.
$$Asset = Liability + Equity$$
in the balance sheet, so as to banks. However, the difference is that banks’ assets are loans and liabilities are deposits from households. If the real interest rate increases, which conveys the increase in the discount rate, then the value of assets for banks would decrease (,by the present value of future cash flows). Liability (debts) keeps constant, then the equity of banks is destroyed.
Eventually, if rates rise enough, the bank may have negative net worth and experience runs, which are destructive of value because all manner of projects, including those viable at prevailing interest rates, are terminated.
Solution
How can this tendency towards banking sector fragility be mitigated?
- Capital Structure of Banks
One possibility is to alter the structure of banks. Long-term loans’ value is more volatile if the real interest rate fluctuates.
If banks financed themselves with long-term liabilities (in part我国政策行if the bank finances through long-term loans, that means A=D+E, `D is also volatile to the real interest rate changes, and moves in the similar direction as Asset) that fell in value as real interest rates rose, banks would be doubly stable. The bank hedge itself, hedging the assets by bank debts.
Deposits from households do not make banks stable, compared with financing through bank loans, because deposits could be withdrawn.
The authors stated that competition that banks strive for efficiency determines the capital structure of banks. I personally do not understand that idea, so I will leave it here.
P.S.
Diamond and Rajan (2001) 中指出，银行，作为金融中介，的功能是有human capital能量化或者保证depositors withdraw时 borrower能提供足够的liquidity还给lender (depositor)的问题。
- 2. Government Intervention
The government may have to intervene to pull the economy or consumption back into place. A typical way of doing so is through lower the interest rate.
The paper states that, reducing interest rates drastically when the financial sector is in trouble, but not raising them quickly as the sector recovers could create incentives for banks to seek out more illiquidity than good for the system. Such incentives may have to be offset by raising rates in normal times more than strictly warranted by macroeconomic conditions.
Put differently, reduce in interest rates could encourage banks to increase leverage or fund even more illiquid projects up front. This could make all parties worse off.
Reference
Diamond, D. and Rajan, R. (2009) (w15197) Illiquidity and Interest Rate Policy. Cambridge, MA: National Bureau of Economic Research DOI: 10.3386/w15197.