Inefficient provision of inside money by banks

We study the role of banks in creating inside money. We show that, even in the absence of asymmetric information or an agency problem, the private provision of inside money is inefficient. The reason is that inside money affects prices and the welfare of non-bank customers, and banks do not internalize this. Under competition, banks tend to generate too much money relative to what is socially efficient, while a monopolistic bank chooses too little money. We argue that a regulator can eliminate these inefficiencies by promoting competition and imposing a ceiling on the loan-to-deposit ratio of each bank. * We would like to thank David Abrams, Itay Goldstein, Jonathan Klick, Jeremy Stein, and participants at the ILE/Wharton finance seminar for helpful comments. Oliver Hart gratefully acknowledges financial support from the U.S. National Science Foundation through the National Bureau of Economic Research. Luigi Zingales gratefully acknowledges financial support from the Center for Research in Security Prices (CRSP), the Stigler Center, and the Initiative on Global Markets at the University of Chicago.