By Douglas W. Diamond and Raghuram G. Rajan

Why are banks so reluctant to lend? One possibility is that they worry about borrower credit risk, though worries need to be extreme to justify the substantial drop in term lending. A second is that they may worry about having enough liquidity of their own, if their creditors demand funds. Yet, the many Federal Reserve facilities that have been opened should assuage these concerns.

Perhaps, however, it is not just the fear of being short of funds to meet creditor demands that drives the reluctance of even healthy banks to lend, but the fear of being short of funds if investment opportunities get even better. 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.

This may also explain why markets for some assets have dried up completely. Some distressed banks clearly possess large quantities of mortgage backed securities (which is why they are distressed). They have some hope that the prices of these securities will rise in the future, saving them from prolonged underperformance or even failure. They will be reluctant to sell those assets today. At the same time, potential buyers feel they could possibly get better prices down the line if fire sales occur. While there is a price today that reflects those expectations, it is not a price that the distressed banks want to sell at - essentially, by selling the assets today, they will forego both the upside potential, as well as the ability to put the assets to the government if the value of the assets plunge and the bank is taken over by the government.

From a policy perspective, this suggests that it may be a good thing to get the illiquid assets off the balance sheets of distressed banks, for that will eliminate a future potential profit opportunity (the potential fire sale) that dampens lending today. However, either the distressed banks have to be forced to sell (for example, through supervisory diktat) or the potential buyers have to overpay (for example, through subsidies in the Public Private Partnership) for the assets to be transferred. Alternatively, banks have to be made healthy through sufficient capital infusion and liquidity support so there is no chance they will dump assets while markets are still thin. Yet another alternative is to close the “walking wounded” down, and take the illiquid assets into a government financed analog of the Reconstruction Finance Corporation. However, this may be easier said than done. Some banks may be weak but not insolvent, and therefore not easy to close. Others that are virtually insolvent may be large and interconnected and thus hard to fail. There is no reason, however, why authorities should not prepare the way.

The broader point is that so long as an institutional overhang of the “walking wounded” exists, making future fire sales a possibility, even liquid banks are unlikely to tie up their liquid assets in illiquid term loans. This is why a rapid cleanup of the financial system is needed, if nothing else to not stand in the way of the lending for the recovery when the “green shoots” eventually emerge.

A detailed analysis is available here.

Douglas W. Diamond and Raghuram G. Rajan are professors of finance at The University of Chicago Booth School of Finance

April 20, 2009 6:16pm in Banks, Credit squeeze, Federal Reserve | Comment