Banking: A Mechanism Design Approach

Abstract

We study banking using mechanism design, without prior assumptions about what banks are, who they are, or what they do. Given preferences, technologies, and frictions — including imperfect commitment, monitoring and collateral — we characterize incentive feasible and efficient allocations, and interpret the outcomes in terms of institutions that resemble banks. Our bankers accept deposits and make investments, and their liabilities help others in making transactions (like bank notes, checks or debit cards). This activity is essential: without it, the set of feasible allocations would be inferior. We discuss how many and which agents should be bankers. Agents who are more patient, more visible, have a bigger stake in the system, or have a lower abiltity to liquidate collateral for strategic reasons make better bankers, because they are less inclined to renege on obligations. Other things equal, bankers should have good investment opportunities, but it can be efficient to sacrifice return by using a bank that is more trustworthy — less inclined to renege — since this can aid in making other transactions. We compare these predictions with banking history.

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