A number of studies have formally analysed the possible general equilibrium effects of the special role of banks. In Diamond and Rajan (2005), banks create value added because they have superior skills in assessing entrepreneurs’ collateral and commit to using those skills on behalf of investors by issuing demand deposits.<sup>28</sup> Negative shocks can undermine this role, shrinking the common pool of liquidity and thereby creating spill-overs to other banks and exacerbating overall liquidity shortages. The interbank market, in particular the possibility that it may freeze, is crucial to their model. Other research develops models that also analyse the occurrence of interbank market freezes and the role of such freezes in inducing credit crunches (Freixas and Jorge (2008) and Bruche and Suarez (2010)). Diamond and Rajan (2011) construct a model showing that the possibility of future fire sales means that deeppocketed investors are willing to buy bank assets only at a low price. With banks preferring to hold on to their assets, the credit crunch is exacerbated.<sup>29</sup> The dependence of firms on bank financing influences how monetary policy is transmitted to the real economy through the bank lending channel.<sup>30</sup> Monetary policy actions can affect the ability of banks to lend since it influences the supply of funds that a bank has access to – by affecting the availability of deposit funds and its funding costs more generally – and consequently the amount of loans a bank can make. A monetary contraction, for example will act to increase bank’s funding costs. This will then induce banks to reduce their supply of loans. The decline in the supply of loans, if not offset by firms and households obtaining other forms of financing, in turn, negatively impacts aggregate output because it constraints households’ consumption and (small) firms’ investment. The bank lending channel can thus explain why policy rate decisions affect the supply and cost of credit by more than the sole impact of the policy rate move (see Claessens and Kose (2017) for a discussion of the interest rate channel).

The credit and liquidity roles of banks also have implications for banks’ organisation as well as their regulation and supervision (see BCBS (2016) for a review). A unique aspect of banks’ maturity transformation and liquidity provision process is their use of demand deposits that are “redeemable” at par and on request.<sup>31</sup> This makes banks vulnerable to liquidity runs 28 Holmström and Tirole (1998) represents the pioneering study of the special role of banks in a general equilibrium environment. For models that endogenise the superior skills of banks in collecting entrepreneurs’ collateral, see Habib and Johnsen (1999) and Araujo and Minetti (2007).

29 Gorton and Huang (2004) show how, in an environment in which private investors make inefficient project choices (eg as they cannot accumulate the liquidity needed to buy the assets of distressed financial institutions), the government can provide liquidity and help mitigate such inefficient choices. Lorenzoni (2007) shows that competitive financial contracts can result in excessive borrowing ex ante and excessive volatility ex post in an economy with financial frictions and hit by aggregate shocks. 30 Early surveys of the literature on the bank lending channel include Bernanke (1993), Bernanke and Gertler (1995), Cecchetti (1995), Hubbard (1995) and Peek and Rosengren (1995a). As discussed later, there are also studies highlighting the importance of risk-taking by banks in their lending decisions (eg Disyatat (2011) and Borio and Zhu (2012)).

31 A number of studies (Calomiris and Kahn (1991), Kashyap et al (2002), Diamond and Rajan (2001) and Huberman and Repullo (2014)) explain why banks fund themselves with short maturities given those risks. These models generally rely on the disciplining features of short-term debt and the beneficial tension between making illiquid loans to borrowers and providing liquidity on demand to depositors. While other intermediaries, such as money market funds, are also vulnerable to runs, as seen during the GFC (Schmidt et al (2016) and Covitz et al (2013)), they generally do not lend and take short-term on-demand deposits at the same time. They are also thought to be “less special,” in that their intermediation functions can be more easily replaced, although the GFC raised questions about such an assumption.

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