Why Bank Money Creation?

Abstract

We provide a rationale for bank money creation in our monetary system by examining 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 when providing deposits such that banks have enough “skin in the game” and monitor loans. When there is unobservable heterogeneity among banks with regard to their monitoring efficiency, aggregate bank lending 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 bank lending 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.