Making Money: Commercial Banks, Liquidity Transformation and the Payment System

Abstract

We consider the interaction between the roles of a bank as a facilitator of payments in the economy and as a lender. In our model, banks make loans by issuing digital claims to an entrepreneur, who then uses them to pay for inputs. Issuing digital claims has two effects on a bank’s liquidity. First, some of these claims used as payment are cashed in before the project is over, necessitating transfers in the inter-bank market to meet these intermediate liquidity needs. Second, the lending bank must transfer reserves to the other banks when the project is done to settle its claims. Each of these transfers has a cost; the endogenous interest rate in the inter-bank market and a settlement cost for final transfers. These costs, in turn, are frictions that affect bank lending. Banks in our model are strategic. If productivity is similar, a high cost of final transfers leads to a coordination friction and multiple equilibria, with each bank trying to match the average number of digital claims issued by other banks. We consider the effects of financial innovations (i.e., FinTech) on the payments system and show that a reduction in the need for intermediate liquidity can lead to an increase in the inter-bank interest rate, because it also induces each bank to increase its lending. We also show that innovations may shift investments from more productive to less productive regions.