Private Money and Banking Regulation ⇤

We show that the regulation of lending practices is desirable for the optimal provision of private money. In an environment in which bankers cannot commit to repay their creditors, neither an unregulated banking system nor a form of narrow banking in which banks hold 100% in reserves can provide the socially efficient amount of money. If 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 credit markets) will mitigate the commitment problem. If the return on the banking sector’s assets is made sufficiently large, then it is possible to implement an efficient allocation.