Banking in General Equilibrium

Abstract

This paper attempts to provide a step towards understanding the role of financial intermediaries ("banks") in aggregate economic activity. We first develop a model of the intermediary sector which is highly simplified, but rich enough to motivate several special features of bauks. Of particular importance in our model is the assumption that banks are more efficient than the public in evaluating and auditing certain information --intensive loan projects. Banks are also assumed to have private information about their investments, which motivates the heavy reliance of banks on debt rather than equity finance and their need for buffer stock capital. We embed this intermediary sector in a general equilibrium framework, which includes consumers and a non-banking investment sector. Mainly because banks have superior access to some investments, factors affecting the size or efficiency of banking will also have an impact on the aggregate economy. Among the factors affecting intermediation, we show, are the adequacy of bank capital, the riskiness of bank investments, and the costs of bank monitoring. We also show that our model is potentially useful for understanding the macroeconomic effects of phenomena such as financial crises, disintermediation, banking regulation, and certain types of monetary policy.