By Hajime Tomura
This paper presents a dynamic general equilibrium model where asymmetric information about asset quality leads to asset illiquidity. Banking arises endogenously in this environment as banks can pool illiquid assets to average out their idiosyncratic qualities and issue liquid liabilities backed by pooled assets whose total quality is public information. Moreover, the liquidity mismatch in banks’ balance sheets leads to endogenous bank capital (outside equity) requirements for preventing bank runs. The model indicates that banking has both positive and negative effects on long-run economic growth and that business-cycle dynamics of asset prices, asset illiquidity and bank capital requirements are interconnected.
It is not straightforward to model the functions of a bank efficiently, in particular the maturity transformation and the resulting demand for liquidity. This is an attempt at it that is able to answer some macroeconomic questions, even if the model turns out to be quite complex.