How can banks create safe money? Balance competition
By Áine Doris – A conundrum underscores the banking system: banks issue liquid deposits but at the same time supply loans to finance illiquid projects, such as startups. In doing this, they expose themselves to liquidity risk—the kind that can lead to bank runs. It’s a precarious way to build a banking system.
Chicago Booth PhD candidate Douglas Xu tackles this liquidity paradox in a model that identifies two market failures or “inefficiencies” that regulators and policy makers need to keep in balance to reduce systematic risks.
Banks have long occupied a critical role in the creation of money. In today’s global economy, governments create only 3 percent of the money exchanged for goods, products, and services: the paper money and coins issued by central banks or monetary authorities whose trustworthiness or integrity underscore their value. Banks create the rest of the world’s cash—a staggering 97 percent.
From early record-keeping tokens to today’s deposit taking and loan making, banks have long been in the business of issuing money-like assets in one form or another. These assets function as credible payment media and thereby facilitate the kinds of activities and transactions that drive economic fluidity and growth.
But these assets bring inherent risk. Xu created a framework that captures the way that banks create money in the economy and integrates two key concepts: banks’ intrinsic vulnerability to illiquidity, and the so-called money-multiplier effect—the chain of transactions created when a bank makes a loan that generates a concomitant deposit elsewhere in the system. Put simply, loans generate a fresh supply of deposits. more>