A conundrum underscores the banking system: banks issue liquid deposits but at the same time supply loans to finance illiquid projects, such as startups. In doing this, they expose themselves to liquidity risk—the kind that can lead to bank runs. It’s a precarious way to build a banking system. 

Chicago Booth PhD candidate Douglas Xu tackles this liquidity paradox in a model that identifies two market failures or “inefficiencies” that regulators and policy makers need to keep in balance to reduce systematic risks.

Banks have long occupied a critical role in the creation of money. In today’s global economy, governments create only 3 percent of the money exchanged for goods, products, and services: the paper money and coins issued by central banks or monetary authorities whose trustworthiness or integrity underscore their value. Banks create the rest of the world’s cash—a staggering 97 percent. 

From early record-keeping tokens to today’s deposit taking and loan making, banks have long been in the business of issuing money-like assets in one form or another. These assets function as credible payment media and thereby facilitate the kinds of activities and transactions that drive economic fluidity and growth. 

But these assets bring inherent risk. Xu created a framework that captures the way that banks create money in the economy and integrates two key concepts: banks’ intrinsic vulnerability to illiquidity, and the so-called money-multiplier effect—the chain of transactions created when a bank makes a loan that generates a concomitant deposit elsewhere in the system. Put simply, loans generate a fresh supply of deposits.

Xu’s framework also identifies two potential inefficiencies that can hamper both the safety and the money-multiplier potential of banks’ deposits.

First, it’s important to have a common liquidity pool—a collective supply of funds that banks can dip into when they are hit by liquidity shocks and need short-term funding, perhaps to avoid bankruptcy. 

But banks may have little incentive to create a large pool. Doing so might undermine their operational liquidity in the immediate term, says Xu. Moreover, when shocks hit, and banks trade among themselves, they may refrain from cooperating for fear of giving their counterparties bargaining power and jeopardizing their own profits. 

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Competition between regional banking systems can help attenuate this problem, says Xu. In a competitive market, shocked banks can raise deposits by bargaining with and borrowing from banks doing business elsewhere. Then, knowing that they can do business with these “foreign” banks if they need to, local banks have more incentive to increase the liquidity pool. 

But there’s a second problem. In times of systemic shocks, such as the global banking crisis of 2008, banks that have been competing with each other may be forced to dip into the same shared liquidity pool simultaneously. Thus, in Xu’s model, competition in banking markets is a mixed blessing: too little and there’s less incentive to create a liquidity pool for the good of all, but too much and there’s a risk that many banks will need to tap into this pool all at once, and will drain it. 

The onus is on regulators and policy makers, says Xu, to find a way to balance the effects of competition in the banking sector, and to prioritize incentives that ensure a common liquidity pool.

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