Banking and Liquidity

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

Despite a growing interest among academics in both the microeconomics of banking and the micro-macro links, there has been very little work on why the institutional form of the bank - the financing of illiquid loans with demandable demand deposits -makes sense. But this issue is at the center of almost all questions about banking: It is central to recent work on the transmission of monetary policy. If the lending channel shuts down because demandable deposits become prohibitively costly, we have to understand why it is critical that loans be financed with demand deposits. It is central to issues of crisis management. What kinds of interventions will help revive a failing banking system? It is central to the design of a financial system. Do we really need banks -can other institutions substitute? In a sense, many of the recent models addressing these issues are incomplete because they address important issues without a fully specified rationale for the form of the banking firm. In a project funded by the NSF that is about to end, the investigators develop a model of the bank that rationalizes its institutional form. They argue that through demand deposits, banks provide more value to depositors than the market value of the illiquid loans they hold. Moreover, banks' ability to issue demand deposits helps them shield borrowers from sudden demands for liquidity from investors. Taken together, the bank's institutional structure enables it to create liquidity on both sides of the balance sheet. In the proposed project, the investigators want to embed the rich, albeit partial equilibrium, analysis of optimal bank and borrower contracting that they developed over the course of the previous project in a general equilibrium setting to understand the consequences of various shocks, regulations, and government interventions on the state of the banking system in particular, and the economy in general. The objective is to obtain a better understanding of the relationship between the various tools of regulatory or macroeconomic policy, banking, and aggregate economic activity.