DP17753 Why Bank Money Creation?
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.
