Martine Quinzii, University of California Davis und Michael Magill, University of Southern California – Equilibria and Optimality of a Flexible 100% Reserve System
This paper studies an institutional framework, more flexible than the 100 % Reserve System, which permits the banking sector to induce an efficient allocation of investment. The key constraint faced by the banking system is that a significant proportion of its sources of funds are required to generate a safe return, even though the banks' investments are unavoidably risky. All the deposits received by the banks are transferred to the Central Bank which guarantees a safe rate of return, and lends back all or part of the funds to the banks at a different rate of interest. We analyze the equilibria of the resulting system and show that, by an appropriate choice of the interest rate on deposits and capital requirements for banks, a Pareto optimal (or when there are costs of bankruptcy a second best optimal) allocation of investment can be obtained.