Optimal Banking System for Private Money Creation

By taking deposits and making loans, banks create private money in an economy– the bank deposits. In this paper I study how the banking system should be designed such that banks can most efficiently create these money-like assets that are both liquid and safe. An endogenously created common pool of liquidity is at the core of this private money creation process– loans made by one bank can generate fresh supply of liquidity to the banking sector before they pay off, which helps to ensure the safety of bank deposits under the exposure to liquidity shocks. I show that under a setting of incomplete markets and incomplete contracts, three market failures potentially plague the private creation of safe assets. First, an incentive problem can lead to ex-ante underproduction of the liquidity pool, when banking sector is subject to idiosyncratic liquidity risks. Second, a commitment problem can result in ex-post over-use of the liquidity pool, when banking sector is subject to systemic liquidity risks. Interestingly, more competitive banking markets ensure more efficient ex-ante incentive provision and hence alleviate the under-production problem; however, increased competition also introduces an ex-post commitment issue, which exacerbates the over-use problem. Finally, an ex-ante coordination problem potentially arises when banking markets become sufficiently competitive: no private safe assets can be created in the economy without proper liquidity regulations (e.g. uniform reserve requirements) being imposed. The analysis has implications on regulations of banking markets and bank liquidity for enhancing economy’s resilience to negative shocks.