Why Bank Money Creation?
Center for Financial Studies Working Paper No. 678
62 Pages Posted: 3 May 2022
Date Written: April 27, 2022
We provide a rationale for bank money creation in our current monetary system by investigating its merits over a system with banks as intermediaries of loanable funds. The latter system could result when CBDCs are introduced. In the loanable funds system, households limit banks’ leverage ratios when providing deposits to make sure they have enough “skin in the game” to opt for loan monitoring. When there is unobservable heterogeneity among banks with regard to their (opportunity) costs from monitoring, aggregate lending to bank-dependent firms is inefficiently low. A monetary system with bank money creation alleviates this problem, as banks can initiate lending by creating bank deposits without relying on household funding. With a suitable regulatory leverage constraint, the gains from higher lending by banks with a high repayment pledgeability outweigh losses from banks which are less diligent in monitoring. Bank-risk assessments, combined with appropriate risk-sensitive capital requirements, can reduce or even eliminate such losses.
Keywords: monetary system, banking, money creation, loanable funds, capital requirements, leverage constraint, asymmetric information, moral hazard, CBDC
JEL Classification: E42, E44, E51, G21, G28
Suggested Citation: Suggested Citation