Despite the government's best efforts, many banks still aren't lending to consumers. Why? Some say they're scared that borrowers won't be able to pay them back or they're already too strapped to hand out any more cash. Douglas Diamond and Raghuram Rajan from The University of Chicago Booth School of Finance have another idea. They say it's "the fear of being short of funds if investment opportunities get even better." They write:

Take, for example, the possibility that a large indebted financial institution becomes distressed in the future and starts dumping assets in the market.
Not only will the price of those assets fall if there are only a few entities with the liquid funds to buy them, the absorption of market liquidity by the distressed institution will ensure that it will be very hard for any institution that does not already have liquid funds to borrow at that time. If financial institutions expect that those with liquidity could make a killing in the future (by buying financial assets or banks at fire sale prices), they will restrict their lending or investment today to very short maturities or liquid securities and not lock up liquidity in term loans.
The point is that it need not be "own" distress that prevents a bank from lending, expectations of liquidity shortages that may cause other distressed entities to sell in a future fire sale can be enough.

The Financial Times Economists' Forum has a short summary of their paper, but you can read the entire thing here.

categories: Recommended Reading

1:15 - April 21, 2009

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