Debt maturity influences debt overhang, the reduced incentive for highly levered borrowers to make real investments because some value accrues to debt. Reducing maturity can increase or decrease ...overhang even when shorter term debt's value depends less on firm value. Future overhang is more volatile for shorter term debt, making future investment incentives volatile and influencing immediate investment incentives. With immediate investment, shorter term debt typically imposes lower overhang; longer term debt can impose less if asset volatility is higher in bad times. For future investments, reduced correlation between assets-in-place and investment opportunities increases the shorter term debt overhang.
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Banks finance illiquid assets with demandable deposits, which discipline bankers but expose them to damaging runs. Authorities may not want to stand by and watch banks collapse. However, ...unconstrained direct 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 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.
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Is there any need to clean up a banking system by closing some banks and forcing others to sell assets if the risk of a crisis becomes high? Impaired banks that may be forced to sell illiquid assets ...in the future have private incentives to hold, rather than sell, those assets Anticipating a potential fire sale, liquid buyers expect high returns, reducing their incentive to lend. Privately optimal trading decisions therefore lead to a worse fire sale and a larger drop in lending than is necessary. We discuss alternative ways of cleaning up the system and the associated costs and benefits.
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What caused the financial crisis that is sweeping across the world? What keeps asset prices and lending depressed? What can be done to remedy matters? While it is too early to arrive at definite ...answers to these questions, it is certainly time to offer informed conjectures, and these are the focus of this paper.
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Why do firms choose high debt when they anticipate high valuations, and underperform subsequently? We propose a theory of financing cycles where the importance of creditors' control rights over cash ...flows ("pledgeability") varies with industry liquidity. The market allows firms take on more debt when they anticipate higher future liquidity. However, both high anticipated liquidity and the resulting high debt limit their incentives to enhance pledgeability. This has prolonged adverse effects in a downturn. Because these effects are hard to contract upon, higher anticipated liquidity can also reduce a firm's current access to finance.
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Liquidity, pledgeability, and the nature of lending Diamond, Douglas W.; Hu, Yunzhi; Rajan, Raghuram G.
Journal of financial economics,
March 2022, 2022-03-00, 20220301, Volume:
143, Issue:
3
Journal Article
Peer reviewed
Open access
We develop a theory of how corporate lending and financial intermediation change based on the fundamentals of the firm and its environment. We focus on the interaction between the prospective net ...worth or liquidity of an industry and the firm’s internal governance or pledgeability. Variations in prospective liquidity can induce changes in the nature, covenants, and quantity of loans that are made, the identity of the lender, and the extent to which the lender is leveraged. We offer predictions on how these might vary over the financial cycle.
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Liquidity Shortages and Banking Crises DIAMOND, DOUGLAS W.; RAJAN, RAGHURAM G.
The Journal of finance (New York),
April 2005, Volume:
60, Issue:
2
Journal Article
Peer reviewed
Open access
We show in this article that bank failures can be contagious. Unlike earlier work where contagion stems from depositor panics or contractual links between banks, we argue that bank failures can ...shrink the common pool of liquidity, creating, or exacerbating aggregate liquidity shortages. This could lead to a contagion of failures and a total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity and solvency problems interact and can cause each other, making it hard to determine the cause of a crisis. We propose a robust sequence of intervention.
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In legal systems with expensive or ineffective contract enforcement, it is difficult to induce lenders to enforce debt contracts. If lenders do not enforce, borrowers will have incentives to ...misbehave. Lenders have incentives to enforce given bad news when debt is short-term and subject to runs caused by externalities across lenders. Lenders will not undo these externalities by negotiation. The required number of lenders increases with enforcement costs. A very high enforcement cost can exceed the ex ante incentive benefit of enforcement. Removing lenders' right to immediately enforce their debt with a "bail-in" can improve the ex ante incentives of borrowers.
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10.
A Theory of Bank Capital Diamond, Douglas W.; Rajan, Raghuram G.
The Journal of finance (New York),
December 2000, Volume:
55, Issue:
6
Journal Article
Peer reviewed
Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creating a role for outside bank capital. Greater bank ...capital reduces the probability of financial distress but also reduces liquidity creation. The quantity of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, costs of bank distress, and the ability to force borrower repayment. The model explains the decline in bank capital over the last two centuries. It identifies overlooked consequences of having regulatory capital requirements and deposit insurance.
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