The former RBI Governor, Dr Y. V. Reddy, will be pleased by the conclusions of this paper. He strongly believes that you should carry an umbrella even on a sunny day, in case it rains.

Applied to central banks, this means that they can reduce financial fragility by raising interest rates more quickly in normal times, that is, when they have the economic and political space to do so rather than scramble like bewildered chickens when bad times descend.

More importantly, this would offset their propensity to reduce rates when the banking system is in trouble, which is usually the knee-jerk response to system-wide adversity.

But that is not the only advantage of carrying an umbrella on a sunny day. Being proactive on interest rates can be an important way of gaining credibility. Inflation control alone need not be their leitmotif.

These suggestions form part of a recent NBER working paper (No 16994) Illiquid Banks, Financial Stability and Interest Rate Policy , authored by Douglas W. Diamond and Raghuram Rajan, both faculty at the Booth School of Business, University of Chicago.

Intervene, don't recapitalise

The authors also say that interest rate intervention by central banks to relieve financial stress may be better than alternatives such as direct recapitalisation of banks or lender-of-last-resort loans to banks.

Their research shows that a willingness to recapitalise banks directly at times of stress will undermine the discipline induced by private capital structures. Such intervention can undermine private commitment and make the system worse off.

Undirected interest rate intervention, where the central banks lend to any solvent bank that needs funds, may be better. This is because undirected interest rate intervention preserves the commitment induced by private contracts even while restoring flexibility to the system by bringing down rates in a way that private contracts cannot achieve.

The paper recognises that central banks' willingness to intervene when liquidity needs are high by pushing down interest rates ex post does not just affect expectations of real interest rates; it also encourages banks to make commitments that increase the need for intervention.

Expectation of low real interest rates can increase the future need for low rates.

To mitigate this, the central bank may have to commit to push the interest rate above the natural equilibrium rate in States where liquidity needs are low, to offset the incentives created by its lowering them when needs are high, the paper has said.

The paper also looks at why episodes of systemic financial sector illiquidity arise and why private arrangements may be insufficient to alleviate them.

The authors have also shown through the paper that unconstrained intervention (lending with no penalty) will make the system worse off. Unconstrained bailouts undermine the disciplinary role of deposits. Unconstrained public intervention undermines the discipline induced by private contracts. By contrast, constrained intervention to lower rates maintains private discipline, while offsetting contractual rigidity.

The NBER paper has noted that arm's length lending by the central bank with a non-pecuniary penalty results in effective interest rate intervention, allowing it to implement the ex-post socially optimal household friendly policy.

The key to intervening without undoing the private commitment inherent in demand deposits is to require that the central bank only makes arm's length loans, not grants, to solvent banks.

Also, a small additional non-pecuniary cost for bankers will ensure that banks exhaust the private deposit market before they turn to the central bank.

Do it differently

In the aftermath of the global financial crisis of 2008, most banking regulators are focused on changing incentives in the banking system. They hope this would change behaviour.

As part of post-crisis reforms, banks in the developed world are now faced with the surge of re-regulation, which will raise their costs, trim their profits and force customers to look for cheaper banking services.

This paper has not gone very deeply into the financial crisis of 2008-09 or made a direct analysis of it.

But, it certainly points out that the focus on the perverse effects of anticipated low interest rates did help in understanding the build-up of illiquidity and leverage, which contributed to the 2008-09 crisis.

The fact that there has been empirical work discussing the responsibility of low short term interest rates in the US from 2003 to 2006 as well as the “Greenspan Put” (interpreted as following asymmetric interest rate policy) for the crisis has been brought out in the paper.

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