Commercial Banks, Liquidity Transformation & Payment System
We consider banks as both payment processors and as lenders. In our model, banks make loans by issuing digital claims to entrepreneurs, who use these claims to pay merchants for inputs in a long-term project. Payment flows lead to two types of liquidity demand. In the interim, merchants cash in some digital claims before the project is over, necessitating intermediate transfers in the interbank market. Ex post, final settlement requires the lending bank to transfer reserves to other banks. Each of these transfers has a cost; the endogenous interest rate in the interbank market and a settlement cost for final transfers. We characterize equilibrium in the model and consider the effects of financial innovation (i.e., FinTech) in the payment system. We show that a reduction in the need for intermediate liquidity induces each bank to increase its lending, improving productive efficiency, but can also lead to an increase in the interbank interest rate. Innovations that increase inter-zonal commerce shift investment from more productive to less productive regions, decreasing productive efficiency.
Dr Chau Chak Wing Building
