Inside Money, Business Cycle, and Bank Capital Requirements

Abstract A search theoretical model is constructed to study bank capital requirements in a perspective of inside money. In the model bank liabilities, backed by bank assets, are useful for exchange, while bank capital is not. When the supply of bank liabilities is not sufficiently large for the trading demand, banks do not issue bank capital in competitive equilibrium. This equilibrium allocation can be sub-optimal when the bank assets are exposed to the aggregate risk. Specifically, a pecuniary externality is generated because banks do not internalize the impact of issuing inside money on the asset prices in general equilibrium. Imposing a capital requirement can improve welfare by raising the prices of bank assets in both states.