Private Liquidity and Banking Regulation

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 e¢ cient 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 su¢ ciently large, then it is possible to implement an e¢ cient allocation. Thus, the creation of a valuable bank charter is necessary for e¢ ciency. Keywords: Private liquidity creation; banking regulation; limited commitment. JEL classi…cation: E40, E42, G21, G28. We thank Guillaume Rocheteau, Mitchell Berlin, Shouyong Shi, Costas Azariadis, and seminar participants at Wharton and the Federal Reserve Bank of St. Louis for helpful comments. We also thank the participants of the 2011 LAEF Workshop on the Organization of Markets at UC Santa Barbara, the 5th Economics of Payment Workshop, and the 11th SAET Conference. yThe views expressed in this paper are those of the authors and do not necessarily re‡ect those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.