A Rationale for the Functional Separation of Qualitative Asset Transformation Services in Banking

Abstract

This paper explores the link between the asset transformation services provided by a bank and the manner in which these assets are optimally funded. This link arises from the fact that asset transformation is distorted by various forms of moral hazard and the resolution of moral hazard is predicated on the type of liability instrument that is used to fund the bank. The demand deposit contract is unable to resolve both types of moral hazards that are modeled. Partial deposit insurance can increase the efficiency of the demand deposit contract but it too fails to provide a complete attenuation of both forms of moral hazard. Efficiency can be enhanced further by functionally separating the various asset transformation services of the bank, suggesting a variant of the "narrow bank" proposal currently being debated.

JEL Classification: D82, G28, G21