The right level of liquidity: A Q&A with Douglas Diamond

Douglas Diamond came to MIT Sloan this fall as the Fischer Black Visiting Professor of Finance and will focus the bulk of his research and study on bank liquidity holdings and financial crises. Diamond, who is on leave from the University of Chicago’s Booth School of Business, recently spoke about his work and his plans.

Could you describe your primary current work?

My work in general is about financial crises and financial intermediaries—banks and hedge funds, and things like that.

One of the things I’m working on is coming up with an analysis of good ways to regulate the holding of liquid assets by banks. The Basel Committee [on Banking Supervision] recommends to central banks around the world what the best practices are for regulation and they came up with two types of new liquidity regulations without presenting any analysis justifying them. There was a belief that if the various banks had been more liquid, so they hadn’t had to sell assets at fire-sale prices, they might have been more stable during the crisis. There was a general idea that maybe it would be a good idea to make them hold a bigger proportion of liquid assets. Another professor from the University of Chicago, Anil Kashyap, and I did a survey of the literature and found that there’s very little analysis of good ways to regulate liquidity. In fact, there’s not even a complete consensus that it needs to be regulated. A friend of mine at Imperial College in London, who is an expert in this area, Franklin Allen, wrote that we don’t even know what to argue about on liquidity regulation.

Does that seem strange to you?

It does. You’d like to find out why you’re doing something before you do it. The Basel Committee had to do something; actually, a lot of my own research says that issues of liquidity and illiquidity are behind things like bank runs [PDF]. Liquidity is clearly an important issue in financial stability, but it’s not the same thing as saying you have to regulate in this particular way. That’s the high-level question we’re trying to get at.

So we’re not at anything close to the optimal regulation of bank liquidity?

There’s an old, well-known paradox about regulating liquidity. The point about having some liquidity around is that if people draw money out, you have assets that you can unload without any losses because they’re so liquid. You want to keep it as a buffer against withdrawals. There’s a bit of a problem, though, when you require people to hold liquidity because it can’t be used to meet the withdrawals—you can’t use; it’s dead. There are some jokes about this because it seems like a contradiction. But in our model, [Kashyap and I] show that in many cases it’s actually not a contradiction because the point of requiring a certain amount of liquidity in particular circumstances is to give the bank incentive to hold the right amount of liquidity in excess of the amount required. Banks may not in general want to hold enough liquidity, but certain well-structured ways of requiring them to hold particular amounts of liquidity gives them proper incentives to hold amounts above that, which would be close to what society would want them to hold.

Are there sufficient safeguards in place now to reduce the likelihood of another 2008?

I think things are probably safer than they were. I think that basically regulation has improved post-crisis in the U.S. and around the world. Most people didn’t really worry about financial regulation a decade ago; many thought that financial regulation was either unnecessary or that it was a bad idea.