Intellectual Merit: The PIs have spent the best part of their careers understanding financial institutions, and the role they play in the economy. In recent years, they have built up from financial institutions. They have studied the role of aggregate real liquidity (as well as the role of aggregate fiat money) on bank behavior. Particularly interesting has been the two-way interactions between banks' asset and liability structures and aggregate variables like liquidity. In their proposed work, they want to examine banker incentives - to set bank leverage, to choose between assets of varying liquidity, and to sell, liquidate, or keep assets - based both on aggregate variables such as liquidity as well as the actions of the government authorities/central bank. They hope thereby to understand the kind of actions banks might take that increase the risk of crises, as well as their behavior in the midst of a crisis. This then allows us to think more carefully about policy, both monetary (the links between monetary policy and risk taking behavior will be one of the important contributions of their work) and regulatory. As the PIs develop these ideas, they will also focus on testing some of the empirical implications of their theories, given the rich data from across the world that will be available from this crisis. Broader Impacts Rajan used some of the ideas the PIs had developed in their earlier work in providing an early warning to central bankers about the potential for a crisis of the kind we have witnessed. The PIs' joint, accessible, paper in the American Economic Review Papers and Proceedings (Diamond and Rajan (2009)), summarizing the causes of the crisis, has been widely downloaded, reprinted, and read. Both PIs have been very active, both in proposing actions to resolve the crisis, as well as in making suggestions for change. Both PIs are members of the Squam Lake Group, a non-partisan group of academics that has put together a set of memos on a number of aspects of regulatory reform. They have interacted with members of the Treasury, the Fed, and Congress, explaining the implications of different reforms in light of their theories. Their current proposal will help us understand better the kinds of incentives that led to the crisis, as well as to the kind of behavior observed in the crisis. Clearly, this will help guide policy formulation for the future. The PIs also hope to train a number of students, both through their teaching (they teach both MBA as well as specialized Ph.D. courses), their Ph.D. advisory role, as well as through their employment of research assistants.
