Banking: A Mechanism Design Approach

Abstract

We study banking using the tools of mechanism design, without a priori assumptions about what banks are, who they are, or what they do. Given preferences, technologies, and certain frictions-including limited commitment and imperfect monitoring-we describe the set of incentive feasible allocations and interpret the outcomes in terms of institutions that resemble banks. Our bankers endogenously accept deposits, and their liabilities help others in making payments. This activity is essential: if it were ruled out the set of feasible allocations would be inferior. We discuss how many and which agents play the role of bankers. For example, we show agents who are more connected to the market are better suited for this role since they have more to lose by reneging on obligations. We discuss some banking history and compare it with the predictions of our theory. We thank many colleagues for their helpful comments and discussions. Wright thanks the NSF for research support. The views expressed in this paper are our own and do not necessarily re ‡ect those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. This paper is available free of charge at www.philadelphiafed.org/research-and-data/publications/working-papers/.

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