This paper presents a dynamic general equilibrium model of banking where asymmetric information about asset quality leads to illiquidity of real assets, liquidity transformation by banks, and bank capital requirements endogenously. The model provides explanations as to why banks can issue liquid liabilities while other assets are illiquid, and why part of bank liabilities must be outside equity, i.e., bank capital. Using this model, this paper analyzes the long-run effects of banking on economic growth as well as business-cycle dynamics of asset prices, asset illiquidity and bank capital requirements in response to productivity shocks and changes in the degree of asymmetric information. This paper also discusses the implications of the model for dynamic bank capital requirements recently discussed in policy forums.
The model is a version of the AK model, where goods are produced from productive real assets (physical capital) and new real assets are produced from goods. In the model, the fraction of agents who can produce new real assets, which is determined by idiosyncratic shocks, is so small that income from these agents’ real assets is not enough to achieve the efficient level of aggregate investment in new real assets. Agents who can produce new real assets can obtain goods from other agents by selling their existing real assets in a competitive secondary market. However, because the productivity of each real asset is private information for the seller in the secondary market, the secondary market price of real assets becomes identical for every real asset sold, undervaluing high-quality real assets. The market’s undervaluation discourages agents who can produce new real assets from selling the high-quality fraction of their real assets, resulting in a decline in the transfer of goods to these agents, which reduces aggregate investment in new real assets. The market’s undervaluation is the definition of illiquidity in this paper.
This basic feature of the model is similar to the findings of Eisfeldt (2004) on illiquidity of real assets due to asymmetric information about asset quality. It is also closely related to the results of Kiyotaki and Moore (2008), who introduce a constraint on the resaleable fraction of real assets in a dynamic general equilibrium model. This paper endogenizes the resaleability constraint in Kiyotaki and Moore’s model as agents choose not to sell the undervalued fraction of their real assets in the secondary market.
The model shows that banking emerges endogenously in this environment. While the illiquidity of real assets leads to agents’ demand for liquid assets, banks can meet this demand as they can pool illiquid assets to average out the assets’ idiosyncratic qualities, which makes the total quality of bank assets public information. As a result, bank liabilities backed by pooled bank assets are priced fairly in the market, i.e., liquid. The model also explains existence of bank capital requirements as the liquidity mismatch in banks’ balance sheets makes self-fulfilling bank runs possible if all bank liabilities are deposits. The holders of bank liabilities require part of bank liabilities to be outside equity (i.e., bank capital) to prevent bank runs.
The comparative statics of the model indicate that banking has both positive and negative effects on long-run economic growth. The positive effect is a direct effect of supply of liquid liabilities by banks, which increases the transfer of goods to agents who can produce new real assets through sales of liquid assets, expanding aggregate investment in new real assets. The negative effect is an indirect general equilibrium effect, or externality, of supply of liquid liabilities by banks, which raises the required rate of returns for illiquid real assets and thus lowers their price. This effect reduces the transfer of goods to agents who can produce new real assets through sales of illiquid real assets. The numerical examples of the model show that the positive effect dominates the negative effect if there is no intermediation cost for banking, but that this is not the case if the intermediation cost is large.
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Liquidity Transformation and Bank Capital Requirements
