Money, financial stability and efficiency

Most analyses of banking crises assume that banks use real contracts. However, in practice contracts are nominal and this is what is assumed here. We consider a standard banking model with aggregate return risk, aggregate liquidity risk and idiosyncratic liquidity shocks. We show that, with non-contingent nominal deposit contracts, the first-best efficient allocation can be achieved in a decentralized banking system. What is required is that the central bank accommodates the demands of the private sector for fiat money. Variations in the price level allow full sharing of aggregate risks. An interbank market allows the sharing of idiosyncratic liquidity risk. In contrast, idiosyncratic (bank-specific) return risks cannot be shared using monetary policy alone; real transfers are needed. ∗We are grateful to Todd Keister, participants at the Bank of Portugal Conference on Financial Intermediation in Faro in June 2009 and at workshops at the Federal Reserve Banks of Chicago and New York, the Sveriges Riksbank, the University of Maryland and the University of Pennsylvania for helpful comments.