Private Liquidity and Banking Regulation
45 Pages Posted: 15 May 2012
Date Written: May 2012
Abstract
We show that the regulation of bank lending practices is necessary for the optimal provision of private liquidity. In an environment in which bankers cannot commit to repay their creditors, we show that neither an unregulated banking system nor narrow banking can provide the socially efficient amount of liquidity. If the bankers provided such an amount, then they would prefer to default on their liabilities. We show that a regulation that increases the value of the banking sector’s assets (e.g., by limiting competition in bank lending) will mitigate the commitment problem. If the value of the bank charter is made sufficiently large, then it is possible to implement an efficient allocation. Thus, the creation of a valuable bank charter is necessary for efficiency.
Keywords: Private liquidity creation, banking regulation, limited commitment
JEL Classification: E40, E42, G21, G28
Suggested Citation: Suggested Citation
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