Do Banks Have A Future

Journal of Banking & Finance 25 (2001) 2239±2276
www.elsevier.com/locate/econbase
Do banks have a future?

A study on banking and ®nance as we move
into the third millennium
Biagio Bossone *
International Monetary Fund, 700 19th Street, N.W., Washington, DC 20433, USA
Accepted 10 April 2001
Abstract
Are banks special intermediaries? Do they play any unique role in the economy? And
if so, will they retain their specialness in the ever-faster changing world of ®nance? The
rapid evolution of ®nance over the last two decades and the breathtaking ``e-age''
revolution have persuaded many that, eventually, banks will be indistinguishable from
other ®nancial intermediaries since all their functions can, at least as eciently, be
carried out by nonbanks. This study re-explores the issue of the specialness of banks in
light of the large existing literature on the subject, and presents an approach which
identi®es the banks' specialness with their unique capacity to lend out claims on their own
debt which the public accepts and uses as money. The study discusses various structural
and policy implications deriving from the approach, and draws on it to point to the
continuing relevance of banking in a world where nonbanks are taking business away
from banks, lending to production has become relatively less important, and the use of
e-money may soon be dominating ®nancial transactions. Ó 2001 Elsevier Science B.V.
All rights reserved.
JEL classi®cation: D51; D92; E51; G21
Keywords: Banking; Circuit theory; E-money; Financial intermediation; Money; Pay-
ment systems
*
Tel.: +1-202-623-6996.
E-mail address: bbossone@imf.org (B. Bossone).
0378-4266/01/$ - see front matter Ó 2001 Elsevier Science B.V. All rights reserved.
PII: S 0 3 7 8 - 4 2 6 6 ( 0 1 ) 0 0 1 9 6 - 0
2240 B. Bossone / Journal of Banking & Finance 25 (2001) 2239±2276
1. Do banks have a future?
Progress in ®nance seems largely to coincide with a lesser role of traditional

banking in the ®nancial intermediation business (Allen and Santomero, 2001).
This may cause one legitimately to wonder whether the future of ®nance in the
new millennium contemplates at all any meaningful role for deposit-taking and
loan-making activities, typically associated with banks as we have come to
know them.
The question relates to the other, which has been repeatedly addressed in the
®nancial economics literature over the last two decades, as to what is really special
about banks. This question becomes ever more pertinent in an era where non-
banks can do as much, and more, than what once was in the exclusive domain of
banks.
But can nonbanks replicate traditional banking and replace banks in their
basic functions? If so, is this cost neutral to the society? Could it be that bank
deposits and loans are becoming so obsolete that traditional banking will
eventually be relegated to no more than a marginal role in ®nancial inter-
mediation? In other words: are transaction costs and information asymmetries
being so dramatically reduced in modern ®nancial systems that what was once
special about issuing liquid liabilities and ®nancing illiquid assets is hardly
special at all, today?
These issues are the subject of this study. After reviewing the reasons of-
fered in the literature of why banks are regarded as special intermediaries
(Section 2), the study shows that banks are (and will remain) special because
of their unique capacity to ®nance production by lending their own debt
to agents willing to accept it and to use it as money. The study explains
that banks and nonbank ®nancial intermediaries perform dierent and com-
plementary functions, equally essential to the economy (Section 3), and illus-
trates various structural and policy implications deriving from this view of
banks (Section 4). Finally, the study discusses the continuing relevance of
banks in a world where nonbanks take away increasing market shares from
them, ®nancing production becomes a relatively less important source of
banking business, and the use of e-money may soon come to dominate ®-
nancial transactions (Section 5). Section 6 ends the study with concluding
remarks.
2. Why banks are special: A review of the literature
The specialness of banks has traditionally been traced to the monetary

nature of their (demand deposit) liabilities and to their running the economy's
payment system. Since the early experience of the deposit-taking institutions of
the 19th century, banks have issued debt instruments that are accepted as
B. Bossone / Journal of Banking & Finance 25 (2001) 2239±2276 2241
means of exchange and payment on the basis of a ®duciary relationship among

the agents using them, and between the agents and the issuing banks.
Supplying transaction and portfolio management services is what de®nes
banking according to Fama (1980), while Kareken (1985) emphasizes the
central role of banks in managing the payment system. 1 Corrigan (1982) adds
to these functions the banks' twofold role of backup sources of liquidity for all
enterprises in the economy and of transmission belt for monetary policy. 2
Others have objected that, with the evolution of ®nancial markets and in-
stitutions, none of the above functions is compellingly and exclusively pertinent
to banks as such. 3 In advanced economies, transaction account facilities are
supplied by nondepository (and even non®nancial) institutions with access to
payment clearing and settlement systems. Likewise, various other ®nancial and
non®nancial entities can provide credit to business, while the backup-source-
of-liquidity function in times of economic distress is in principle inconsistent
with bank regulations aimed to prevent or forestall bank failures. Finally,
where monetary policy is mainly conducted via open-market operations, gov-
ernment securities dealers (even more than banks) may act as transmission
belts of monetary policy signals to the economy.
Research has thus looked for other features that may more speci®cally
characterize banks as special ®nancial intermediaries. 4
2.1. The credit function
Diamond (1984) ®nds a special feature in banks acting as delegated moni-

tors of borrowers, on behalf of the ultimate lenders (depositors), in the pres-
ence of costly monitoring. Essentially, banks produce a net social bene®t by
exploiting scale economies in processing the information involved in moni-
toring and enforcing contracts with borrowers. Banks reduce the delegation
costs through a sucient diversi®cation of their loan portfolio. Even if Dia-
mond's result shows that banks' specialization in monitoring credits improves
social welfare, it does not prove to hold for banks exclusively, since any kind of
intermediary equally bene®ts from portfolio diversi®cation. Also, it does not
explain why loan contracts are not replaced by more ecient risk sharing, more
complete state-contingent contracts that reduce asymmetric information (such
as equities).
1
Kareken himself, however, and Fama (1980) envision regimes where payment transactions are
divorced from banks and are carried out by nonbank entities, or even by individual agents.
2
In revisiting the issue almost two decades later, Corrigan (2000) re-arms his original view.
3
See, among others, Golembe (1983), Golembe and Mingo (1985), and Goodhart (1987).
4
Bhattacharya and Thakor (1993) oer an extensive review of the major issues and research
areas relating to banking intermediation.
What is characteristic of bank loans is that their value is ®xed in nominal

terms and includes collateral requirement clauses as well as costly bankruptcy
provisions. By factoring ex-post information asymmetries and agency costs in
the credit-making process, Gale and Hellwig (1985) show that such contract
types, which they call standard debt contracts (SDCs), are optimal ®nancial
arrangements. These, on the one hand, save on the creditor's costs of moni-
toring states of nature throughout the life of the loan and, on the other, give
borrowers an incentive to minimize the risk of default and discourage them
from hiding their true business performance.
The optimality of SDCs suggests a powerful argument to explain why banks
have historically emerged as the ®rst form of ®nancial intermediation virtually
everywhere in the world whenever capitalistic production had taken place.
However, SDC optimality is not robust against changes in the universal risk-
neutrality assumption used by Gale and Hellwig in their model, and does not
hold in the case of ex-ante information asymmetries, where SDCs become
exposed to adverse selection and moral-hazard risks. 5 Besides, as information
and contract performance are crucial to the SDC optimality result, one would
expect bank specialness to fade with the development of ®nancial infrastruc-
ture, since this provides agents with better information and more ecient
contract enforcement technologies leading investors to prefer non-SDC con-
tract types (e.g., equity). Bank specialness is therefore a product of history,
much like its own disappearance at some point.
Terlizzese (1988) uses the presence of ex-ante asymmetric information as a
rationale for the depositors' preference to lend indirectly (writing a SDC with a
bank) over direct ®nancing of individual entrepreneurs. As depositors are faced
with a ``lemon'' problem, they generate a demand for delegated screening
which banks have a comparative advantage to perform. In a repeated-game
situation, the related agency problem is solved through reputation incentives.
Interestingly, due to the ex-ante information asymmetry, banks should not ®nd
it possible to have depositors agree on deposit contracts contingent on states of
nature. This provides an enlightening explanation for why bank commonly use
SDCs to ®nance their assets.
Through the credit function and the associated access to private informa-
tion, banks tend to establish long-term relationships with fund users, based on
mutual trust and mutually bene®cial incentives. Relationships ensure bor-
rowers with a steady and reliable supply of funding, even at times of adverse
contingencies, while they generate for the banks safe sources of (quasi-
5
Terlizzese (1989) shows that state-contingent contracts (requiring no collateral) are superior to
SDCs in terms of ecient diusion of information and risk sharing, under ex-ante informational
asymmetries.
monopolistic) rents. 6 As relationships consolidate over time, it becomes costly

for both parties to exit and replace them with dierent counterparties. Rela-
tionships, however, are not necessarily a unique feature of banks and can be
replicated by other types of nonbank ®nancial intermediaries, especially those
specialized in term lending.
2.2. The liquidity function
The credit view of bank specialness underscores the relevance of banks'

informational advantage vis- a-vis the ultimate investors (depositors). Banks
specialize in extracting and processing information concerning borrowers in a
way that is not replicable by individual investors. In fact, bank information
may be very exclusive and made unavailable to others. This is tantamount to
saying that loans are illiquid to investors and nonnegotiable in the market. In
spite of this, banks ®nance their loans with liquid deposits bearing nominal
®xed value and available to their holders on demand. The specialness of banks
must thus rest with their capacity to provide liquidity services.
The provision of liquidity services pre-eminently characterizes banks in the
classical contribution by Diamond and Dybvig (1983). Instead of placing their
endowments in an illiquid production technology, individuals deposit them with
banks in exchange for (interest-bearing) claims entitling them to withdraw the
deposits to ®nance future, unanticipated consumption needs (with uninsurable
risk of occurrence). Depositors gain consumption ¯exibility. Their requests of
withdrawals, however, are served sequentially, on a ®rst-come-®rst-serve basis,
until the bank runs out of assets; thus, each depositor faces a positive risk of
being unable to exercise her claim if the bank runs out of assets before her re-
quest is submitted. The return on deposits, on the other hand, enables deposi-
tors to achieve higher future consumption than if they realized the illiquid
assets. Banks therefore provide depositors with a liquidity insurance service,
and allow money to be transferred from patient holders to impatient consumers.
However, any nondeposit type of money (say, cash) would provide at least
the same kind of consumption ¯exibility that the Diamond±Dybvig deposits
provide (although at a dierent risk±return tradeo). The specialness of banks
must therefore originate from their being able to transform liquidity into
optimal illiquidity in the agent portfolios, by eciently exploiting at the mar-
gin the depositors' preferred tradeo between consumption ¯exibility and in-
tertemporal consumption. The result is an instrument which is riskier and
higher-paying than cash, but which works like cash. This is possible if the
6
For a recent and comprehensive review of relationship banking, see Boot (2000) and Rajan and
Zingales (1999) discuss the costs and bene®ts of relationship banking in the context of ®nancial
development and industrial structural change.
banks use deposits to ®nance illiquid assets that would not be ®nanced by
investors directly, and if they extract from these assets enough rents to remu-
nerate the depositors. 7 Banks are therefore pure intermediaries, and their
specialness must be traced to their ability to integrate optimal illiquidity crea-
tion for depositors with rent-extraction power from borrowers.
In his last testament on money, Sir Hicks (1989) saw the specialness of banks
in their acquired ability to make deposits withdrawable at sight and usable in
payments. He understood this to allow both banks and depositors to use de-
posits as money. He also saw this as enabling banks to hand over money when
they make loans without giving up any cash (or third-party liabilities) but,
simply, by increasing their liabilities: deposit withdrawability and their use for
payments allow banks to create money.
In an innovative contribution, McAndrews and Roberds (1999) emphasize
the power of banks to create liquidity through their role as payment inter-
mediaries between buyers and sellers. As long as the agents hold deposits with
banks and accept to be paid by book-entry transfers, banks can exploit the
osetting nature of multilateral payments and issue overdrafts on their books
(thus creating liquidity) to depositors who demand to make payments in excess
of their deposit claims. Bank deposits therefore remain a superior and cheaper
means of payment than alternative instruments (e.g., mutual fund shares)
which abjure the use of netting credit.
2.3. Integrated functions
Fama (1985) points to the specialness of banks as deriving from integrating

credit and liquidity provision functions. By having borrowers hold deposits
with them, banks can observe cash-¯ow movements and gain private infor-
mation on borrowers, which they then feed into the processing of new loans. 8
This gives banks a special role as information providers to capital market
participants, who incorporate the information embedded in banks' lending
decisions into their own investment evaluations. 9 Though Fama's theory may
explain why transaction- and credit-related services have historically been in-
tegrated within the same type of institution, it is not hard to imagine these
services being increasingly provided by nonbank institutions specialized in
extracting information on payment records of individual borrowers.
7
The social welfare improvement due to private (bank) money backed by productive assets is
discussed by Williamson (1999).
8
Mester et al. (1998) provide evidence of the usefulness of checking account information for
banks to monitor their borrowers.
9
James (1987) and Lummer and McConell (1989) have found evidence supporting this
hypothesis by observing how stock prices reacted for a sample of ®rms after public announcement
of new loan negotiations, revisions, and renewals.
Goodhart (1986, 1987) looks at the peculiar asset and liability structure of
banks. Bank assets determine the nature of bank liabilities: holding assets
mainly in the form of nominally ®xed loans induces banks to issue liabilities
largely in the form of deposits with guaranteed nominal capital value. This
makes banks particularly vulnerable to perceptions of asset deterioration, to an
extent that even requires the setting up of special safety nets. Goodhart em-
phasizes the exclusive nature of the information banks have on borrowers as
the cause for the opaqueness and nonmarketability of loans. 10 It is not clear
though, in Goodhart's explanation, why banks should not be able to use more
ecient risk-sharing types of contract and stick, instead, to SDC types for
lending. If the information inferiority and risk aversion of small depositors
justify the banks' use of SDCs for liabilities, the same does not hold for their
assets since banks do have access to information on borrowers. Moreover, if
banks diversify their assets suciently, there are not compelling reasons why
they should not issue SDCs as liabilities and not use non-SDCs for their in-
vestment.
Calomiris and Kahn (1991) investigate the speci®c liability issued by banks
in the form of demandable debt to ®nance illiquid assets. They show that,
under costly and asymmetric information, demandable debt provides an
incentive-compatible solution to the potential con¯ict of interest between (in-
formed) bankers and (uninformed) bank depositors: the depositors' right to
withdraw their claims from a bank, if they become dissatis®ed with their de-
posit returns, give them an incentive to monitor the bank. If enough of them
agree on a negative assessment of the bank's performance, they can call for
bank liquidation. As a result, demandable debt induces bankers to pre-commit
to a set of agreeable payos to depositors. Obviously, the incentive property
of demandable debt is less and less peculiar of banks, as claims on any (non-
bank) ®nancial intermediary become negotiable in ecient secondary markets
and grant to their holders the power to ``walk out'' of the intermediary at any
time.
Integrating information-intensive lending and payment services distin-
guishes banks from other intermediaries, according to Goodfriend (1991). 11
Systems to evaluate, monitor, and enforce loan agreements are useful both for
processing loans and for managing the implicit or explicit lending associated
with the provision of payment services. As a result, payment services can be
provided at lower costs by entities who also oer credit services.
10
Were it not for such special nature of banking, and if bank assets were marketable, a new form
of deposit liabilities could develop ± Goodhart (1987) argues ± which would be very much similar to
mutual fund shares; their value would re¯ect the value of the intermediary's assets, and could in
principle be used as means of payments. See Fama (1980) as a precursor of this idea.
11
I am grateful to T. Beck for bringing this work to my attention.
Berlin and Mester (1996, 1998) emphasize bank access to interest inelastic
(core) deposits as a special feature that conditions bank lending. Core deposits
insulate the banks' cost of funds from exogenous shocks and allow them to
protect borrowers from credit shocks. Berlin and Mester (1996) ®nd that banks
funded more heavily with core deposits provide more smoothing of loan
rates in response to exogenous shocks to aggregate credit. This type of pro-
tection gives the banks and their borrowers an incentive to undertake multi-
period contractual agreements in which loans need not break even period by
period, and allows banks to charge higher loan rates. One must note, however,
that the eect of core deposits on bank lending is less relevant the more banks
can rely on interbank credit and/or the larger is their relative size (see Section
4.2).
Diamond and Rajan (1998, 1999) introduce banks as superior devices to tie
human capital with real (illiquid) assets. Like Diamond and Dybvig (1983),
they, too, focus on the liquidity insurance services provided by banks but take
the further step of integrating the two sides of the bank balance sheet: banks
create liquidity both for the depositors and the entrepreneurs. Diamond and
Rajan show that the peculiar bank capital structure works as a disciplinarian
device: banks possess speci®c talents to collect the maximal value of loans to
entrepreneurs and to attract deposits from individual investors, as they can
credibly commit to pass on to them the rents they expect to collect from
borrowers. Banks can do so because their capital structure exposes deposi-
tors to liquidity and credit risks, and makes depositors prone to run on
banks if they perceive banks to become insolvent. Since a run would drive
bank rents to zero, the risk of runs provides banks with an incentive to be
credible borrowers. 12 In this respect, runs are no longer an undesirable by-
product of deposit contracts but an essential inducement to sound banking. 13
Kashyap et al. (1999) show that lending with deposit-taking services can be
provided more eciently if they are processed by the same institution. De-
posits, like loan commitments, provide liquidity on demand. Since liquidity
commitments need to be supported by a buer stock of cash and safe securities,
banks can economize on such stock by combining the two types of services
(provided that deposit and loan withdrawals are not strongly mutually corre-
12
This incentive eect is the same as in Calomiris and Kahn (1991).
13
Banks in Diamond and Rajan are intermediaries, but their fragile capital structure allows
them to improve social welfare by eecting maturity and liquidity transformation with only a small
amount of pre-committed ®nancial capital. Note, however, that no ``free-lunch'' factor is at play
here: although Diamond and Rajan do not explore this issue, banks can perform their functions
only if their ®nancial capital is complemented by enough reputational capital to generate deposi-
tors' con®dence that their claims will be honored. Thus, banks may be seen as agents specialized in
bridging trust gaps between investors and fund users for whom the cost of doing so individually is
too high.
lated). Banks can thus hold a smaller buer than would be required by two
intermediaries oering the same services separately. Such economies allow
banks to oer liquidity services to their customers at lower prices than other
intermediaries. 14
3. Why banks are special: The circuit approach
Integrating bank credit and liquidity functions, as proposed by the theo-

ries just reviewed, is necessary to gain an understanding of how banks interact
with the real economy. Yet these theories share one limitation: all implicitly
assume the pre-existence of some form of outside (commodity or reserve)
money that is deposited with banks and is used by banks to extend loans.
All these theories therefore take banks as intermediaries of outside money.
Almost none of them, with few notable exceptions, points out that banks
create money and that money creation makes banks dier from other inter-
mediaries.
Schumpeter (1934) explained this clearly, but his message did not make it
through to today's mainstream theory of banking. Schumpeter understood
banks as being uniquely capable of adding to the existing stock of money by
lending promises to pay, so that the total credit in the system can exceed what
is possible if credit has to be fully covered. And he understood that through
money creation banks generate purchasing power in anticipation of, and for
the production of, new output: bank money is made up of claims on output yet
to be produced. Schumpeter saw that banks do not con®ne themselves to
transferring existing purchasing power from depositors to borrowers. How-
ever, his model was not articulated enough to identify the dierent roles of
banking and nonbanking ®nancial intermediation.
Banks are thus special because they, only, create money in the form of
claims on their own debt, which they inject in the system by lending. Their
specialness lies on their ability to economize on the (costly) use of outside
money with their own deposit liabilities. For over four decades, this has been
the core idea of the research program of the theory of the monetary circuit,
which I have recently revisited (Bossone, 2001a). This theory integrates the real
and ®nancial sides of a monetary production economy in a sequential, ¯ow-of-
funds, general equilibrium framework. With some structural amendments, the
14
Padoa-Schioppa (2000) discusses the regulatory implications of this view. Saidenberg and
Strahan (1999) corroborate it showing that banks maintain a very important role as reliable
suppliers of liquidity to the corporate sector, especially at times of securities market distress. Since
at such times investors revert to bank deposits, banks do not have to run down their buer stock of
liquid assets to provide liquidity to borrowers.
theory sheds light on the dierent and complementary roles that banking and
nonbanking intermediation provides in servicing the real economy. Circuit
theory is not inconsistent with the theories of banking discussed above that
essentially identify the special role of banks with information and liquidity
insurance provision, and contributes to understanding the links between the
(micro) functions of banks and the macroeconomy.
15
3.1. Banks and nonbanks in the circuit approach
Assume an economy with four sectors: ®rms, households, banks, and non-
bank ®nancial intermediaries, and two commodities: one for household con-
sumption and the other for capital accumulation by enterprises. Economic
activity is a one-period process with three phases in a circuit sequence: an
opening phase (circuit start), an interim interval, and a closing phase (circuit
end). The circuit sequence is as follows:
1. At circuit start (phase I in Fig. 1), banks negotiate with ®rms the conditions
for one-period loans. The banks credit the ®rms' deposit account with the
negotiated loan amounts. The ®rms execute production using capital and
labor. Loans are used to pay wages to household workers. Deposits are
transferred from the ®rms' bank accounts to the accounts of wage earners.
2. In the interim interval (phase II in Fig. 1), household incomes are spent
on consumption goods and/or saved. Savings go into bank deposits and/
or into long-term securities issued or traded by ®nancial intermediaries.
Firms wishing to add to their capital stock (investing enterprises) bid for
funding from the intermediaries. These evaluate potential borrowers and al-
locate funds to the viable ones in exchange for securities. The ®nanced en-
terprises buy the capital goods needed. All money transfers and payments
for goods and securities take place through book entries on accounts held
with the banks.
3. At circuit end (phase III in Fig. 1), the ®rms use their proceeds from out-
put sales to payo their bank debt. The money originally created is de-
stroyed.
Appendix A describes the circuit process through a formal model. The

following is a description of the role of each type of agent and their inter-
actions. Individual agents optimize their objective functions, involving satis-
faction from intertemporal consumption for households and pro®ts for
nonhousehold agents, given prices and the information they possess. House-
15
This section and Section 4.1 draw on my previous work on the circuit theory of banking and
®nance, cited above.
Fig. 1. Flow of funds in the circuit model.
holds supply labor services to ®rms and receive wages. Their consumption
varies with their expected income from real and ®nancial assets. Households
invest a share of their savings in long-term ®nancial assets through ®nancial
intermediaries and hold bank deposits for transaction and precautionary
purposes. Portfolio decisions depend on assets' expected returns and income
variability.
Firms employ labor and capital to satisfy the demand for consumption and
capital goods from households and ®rms, respectively. Firms ®nance produc-
tion with short-term bank credit at circuit start and repay banks at circuit end.
Their net pro®ts equal revenues from output sales less capital depreciation and
credit repayment. 16
Banks allow the circuit process to start by providing short-term loans to
®rms to ®nance production. 17 Banks issue debt claims (deposits) redeemable
on demand by holders, transferable, and usable as means of payment. Without
relying on regulatory assumptions, banks here are any agents who possess
enough reputation with the public to be able to issue liabilities which credibly
feature the properties just described.
16
In this model (see also the associated formal version in Appendix A), relative prices are
assumed constant. Thus, the interest rate determines the economy's resource allocation to current
and future consumption and the demand for capital goods.
17
Banks can also supply credit to households and thus support ®rms' output sales. See Section
5.1 and Appendix A.
Banks possess technology and information to select and monitor the risk of
borrowing ®rms and use incentives to ensure loan repayments. Since bank
technologies and information are speci®c to the bank±borrower relationship,
bank loans are not liquid. Loan supply is positive in the price of the loan and
negative in the risk of borrower default. The latter varies directly with both the
amount and the price of the loan. The bank and each ®rm negotiate the price of
the loan, and the bank lends to each ®rm until the price of the loan equals the
®rm's marginal risk of default. The bank seeks to strike the loan price which
maximizes its risk-adjusted pro®ts at the optimal level of lending. The amount
lent determines the maximum output that the borrowing ®rm can produce.
Bank deposits are created when the negotiated loans are credited on the
borrowers' account. The loans give borrowers access to new purchasing power
in the form of deposits that can be used for payments. Deposits are ac-
knowledgments of debt by the banks to those receiving them as a result of
payments and fund transfers. Banks commit to honor such debt as of when
funds are drawn on the loan accounts by the borrowers. No cash circulates in
the economy and all payments and fund transfers are made through deposit
transfers across bank accounts (book entries).
Banks extend credits to each other in the form of credit lines, overdraft, or
netting arrangements; thus, payments do not entail transfers of central bank
money between banks, unless and until the receiving banks require paying
banks to settle their debts in central bank money, or unless and until the
economy's settlement rules require interbank credit/debit balances to be settled
in central bank money. 18
At circuit end, the banks receive debt payments from the borrowing ®rms. If
®rms are unable to payo their debt, the banks have to decide whether to renew
(or rollover) the original loans, restructure them, or write them o as losses.
Deposits are destroyed (and net liquidity withdrawn from the system) when
loans are repaid to the banks.
The nonbank ®nancial intermediaries, or nonbanks, constitute the ®nancial
market of the economy. Nonbanks aggregate investment funds and allocate
them to fund users. They are specialized in assessing the risk and pro®tabil-
ity of alternative investment options and the creditworthiness of the investing
enterprises demanding funds. Nonbanks ®nance investment with long-term
18
The absence of the central bank from the model emphasizes that bank money creation can
take place independently of the traditional money multiplier process, which requires a pre-existing
money base. But even when the money base is included, the demand for it does not necessarily
imply a multiplier process of bank money creation (although, of course, ex-post the money stock
produced by the banks is always a multiple of the base). When the money base is included, it can be
seen as a higher-powered reserve asset that banks hold in a certain ratio to their liquid liabilities as a
liquidity insurance instrument. In fact, banks can always create money, provided that the supply of
the base is suciently elastic for them to keep their desired ratio.
funds generated by savings. They increase their supply of funds up to the point
where the net-of-risk long-term interest charged to the investing enterprises
reaches its maximum, and ration supply thereafter. The long-term interest rate
raises with the dierence between the demand and supply for long-term funds.
All savings from corporate pro®ts and interest incomes are invested in the
capital market; this includes also bank pro®ts that are re-lent to investing
enterprises (since in this case banks act as ®nancial investors).
In a closed economy, the supply of long-term funds from nonbanks to fund
users cannot exceed their collection of savings from investors. In fact, non-
banks do not raise more funds than what they can or wish to invest. Similarly,
if investors prefer deposits to less liquid assets, the nonbanks' demand for
funds is rationed by the limited supply from investors. The investment actually
funded is thus the least between the supply and demand for long-term funds.
In each period, the economy's equilibrium requires that ®rms sell all their
output and that the investing enterprises raise enough funds to settle their
contract obligations with the capital goods producers. If output remains un-
sold, ®rms need to ®nance their unrecovered costs. From the ®nancial stand-
point, at circuit end all deposits must be destroyed, all money incomes must be
spent in consumption and/or investment, and ®rms must payo their debt. If
there are deposits left outstanding, banks need to rollover the credit positions
left open by the borrowers who have not settled their obligations. The circuit
closes when producers use the proceeds from output sales to clear their debt
with the banks and when debts are renewed.
At circuit end, producing ®rms ± as a group ± can appropriate no more than
the money originally injected in the system. This equals the initial bank loans
but does not include the money needed to pay interest. Thus, ®rms as a group
may at most be in a position to payo the principal debt to the banks, while
they need additional money to be able to settle the interest debt share (unless
banks accept payments in kind). This payment problem has nothing to do with
the capacity of the ®rms either to produce and sell additional output, or to
extract a larger surplus from production by lowering the relative price of labor.
It exclusively rests on the liquidity constraint inherent in a circuit process where
a given stock of money, which does not cover for interest payments, is ad-
vanced by the banks to the ®rms at circuit start. 19 Inevitably, interest pay-
ments require in the aggregate new money creation from the banking system
(see Appendix A). Appendix B illustrates the changes that take place in the
balance sheet of each agent acting in the circuit sequence described above, as a
result of their interactions.
19
In fact, increasing productivity or decreasing the real value of wages can only increase ®rms'
real pro®ts (or material surplus) but can in no way help them raise additional cash, if the overall
stock of cash is given.
4. Implications of the circuit approach
4.1. Why banks are special
When the economy is considered in its sequential stages as in the model

above, distinctive roles appear to be played by the credit market, where li-
quidity is created to ®nance new production, and the ®nancial market, where
existing accumulated liquidity is allocated to investments. This implies a dif-
ferent role for banks and nonbank ®nancial intermediaries:
(1) Banks allow the circuit to start by providing new money for new produc-
tion. Such money is in the form of banks' own liabilities, or debt claims on the
banks themselves, that are made available to the borrowers under loan contract
terms. Banks do not intermediate existing money, but add to it every time they
extend new loans to ®rms in the form of new deposit claims, while simulta-
neously committing to honor the deposit claims already outstanding. Banks
specialize in selecting borrowers to whom they allocate the new deposit claims.
(2) Nonbank ®nancial intermediaries allocate existing liquidity (bank de-
posits) from investors with long liquidity positions to fund users with short
liquidity positions. Unlike banks, the money intermediated by ®nancial inter-
mediaries does not represent claims on the intermediaries themselves; such
money consists of claims on banks (i.e., deposits) and, as such, it can only
move across bank accounts. Thus, while intermediaries transfer money across
agents with dierent liquidity preferences, in no case do they create money. 20
By funding investment, ®nancial intermediaries enable capital goods producing
®rms at circuit end to appropriate the money spent in production and to service
their short-term debt obligations to banks. 21
What then de®nes banks is that they (i) issue debt claims on themselves that
are accepted as money by the public, and (ii) inject money into the economy by
lending out claims on their own debt. This way of looking at banks bears two
implications. First, as of the time bank money is created through a loan, it is
simultaneously an asset and a liability both for the issuing bank and for the
borrower who receives the loan. 22 Second, banks issue claims on real resources
yet to be produced; they thus carry a potential for generating both production
and price in¯ation (Mathieu, 1985; Rachline, 1993): which of the two prevails
20
As noted, nothing prevents the public from accepting and using a nonbank liability as money.
In this case, the nonbank would have an incentive to lend by issuing its own liability like a
conventional bank.
21
This function was well recognized already in the thirties by Bresciani Turroni (1936).
22
Banks do not create value and the newly issued money takes on value only when and if it is
associated with new production (Schmitt, 1982; Cencini, 1995).
after the money has been issued is ultimately a function of how well banks
select and manage their risks. 23
To summarize: Banks are special because they can ®nance new production
by creating money; this makes production cheaper than if banks were only to
intermediate claims backed by pre-existing real resources.
4.2. Structural implications
4.2.1. Bank extract seigniorage

In a circuit process, banks command net real resource transfers from the ®rms.
They extract seigniorage. 24 As noted, at circuit end ®rms as a group may at most
appropriate just enough money to payo their principal debt. When ®rms repay
the principal, no net real resource transfer is involved from them to the banks.
Interest payments, however, require ®rms to give in a share of their output in
return for no additional real resources from the banks. Hence, the net transfer. 25
That there is a net real resource transfer from ®rms to banks is explained by
the nature of the interest rate on bank loans. Since banks ®nance loans by
issuing new deposit claims, the interest charged on the loans are not a com-
pensation for foregone consumption and intermediation services. The interest
rate (net of the resource costs to process lending and remunerate deposits) is a
pure rent that banks extract from borrowers by virtue of their exclusive power
to create money.
Such exclusivity rests on the government and the society con®ning ± by law
and convention, respectively ± the acceptance of money only to liabilities issued
by selected agents. No rent would be involved if, hypothetically, all agents
could issue their own liabilities and had them accepted as money by the others.
This same argument explains why changes in the structure of the banking
market (say, changes in competition rules) alter bank seigniorage.
Seigniorage is not extracted by intermediaries, as these only re-allocate
existing liquidity. Unlike interest on commercial loans and like payment for
inputs, interest payments on a company's debt to a ®nancial intermediary
represent a production cost item against the company's revenues. As such, they
are a compensation to investors for parting with liquidity and to intermediaries
for providing intermediation services and, therefore, do not involve net real
resource transfers from the company to the investors and the intermediary.
23
This conclusion dier from neoclassical models where banks play a passive and neutral role
(see, for instance Fama, 1980) on prices.
24
For a discussion of seigniorage in an economy with a banking sector, see Baltensperger and
Jordan (1997).
25
Banks may temporarily shift the obligations to the future by re®nancing their debt over
longer-term maturity, but at some point they would have to relinquish real resources anyway, as
term lenders would not postpone their credit exposure inde®nitely.
The way money enters and ¯ows through the circuit entails also a direct
relationship between seigniorage and the size of a bank. Size is here de®ned as
the bank's share of the deposit market. When bank A extends a loan to a
borrower, it stands a chance that the new deposit claims are transferred to
other banks. The smaller the size of A, the higher the chance of the claims
being transferred to other banks.
When claim transfers occur, bank A incurs open interbank debit positions
which it becomes liable to oset when so required by the creditor banks or by the
extant payment settlement rules. In reality, banks extend credit to each other
subject to limits which usually vary with the size and quality of the borrowing
banks. Typically, the smaller the size of A, the tighter its largest net debit position
accepted by the other banks. Smaller banks, thus, must hold relatively larger
reserves against their debit positions and enjoy lower money creation capacity
than larger banks. 26 With interbank credit limits set to zero or with full collateral
requirements on interbank credit, banks would have no money creation capacity.
On the other hand, less stringent interbank debit limits lower banks' demand for
reserve assets and increase bank money creation capacity. In the extreme, with
unlimited interbank credit, banks would have no incentive to hold reserve assets.
With limited interbank credit, it is convenient for a bank to expand its size.
A larger size increases the re-deposit capacity of the bank, reduces the bank's
obligations arising from lending, and enhances its seigniorage as a result. By
broadening its deposit base (through both larger deposits and more deposi-
tors), the bank increases the number of payments settled within its own books
and, all other things being equal, decreases the number and the volume of its
interbank debit positions. The bank may increase its lending with: (i) a lower
probability that this will generate deposit transfers to other banks and (ii) a
higher probability that deposits will ¯ow back in its own books from other
banks, as a result of payment activity. 27
26
Contrast this with the extreme case of a system with only one bank. Money would circulate as
book entries within the same bank's balance sheet. In this case, irrespective of how fast existing
deposits change hands, and abstracting from in¯ationary and con®dence problems, the bank could
create new money at will, unimpeded by debit osetting requirements. Note that in this case the
bank would be in a position to extend loans of any maturity with no concern about asset±liability
maturity mismatch. Related to size is also the degree of competition among banks, which limits
seigniorage both by restraining the equilibrium level of the interest rate on bank loans and by
leading banks to pay interest on deposits.
27
As an alternative to expanding their scale, banks could join in clearinghouse arrangements
with others and accept each other's payments by extending reciprocal credits. (I am grateful to F.
Mishkin for pointing this out to me.) However, whereas in the case of a clearinghouse arrangement
individual banks' seigniorage would be limited by interbank credit limits and conditions, a single
bank that would clear the same volume of payments in its own books would not be subject to the
same limitations: it would internalize the bene®ts from centralizing the accounts by eliminating the
costs of interbank lending. Moreover, the clearinghouse argument does not invalidate ± and in fact
supports ± the conclusion that seigniorage increases faster than size.
4.2.2. Banks tend to accumulate corporate ownership and control

Firms settle their bank debt by transferring real resources to the banks. Real
resource transfers may include direct sales of output, payments out of pro®ts,
and transfers of ®xed asset (e.g., real estate) and of equity claims. Settlements
may also involve transfers of funds borrowed from the ®nancial market, but
this solution is not sustainable over time.
While direct output sales make a small share of the nondebt forms of set-
tlement, ®xed asset claim transfers are limited by the ®rms' stocks of market-
able assets. Thus, in the long run, ®rms can settle their debt only by using their
gross pro®ts and/or by selling equity to the banks or the public. Equity sales
allow ®rms to transfer to the banks claims on their future income as well as
control over their future income-earning capacity.
For given (desired) levels of pro®tability, the use of pro®ts to settle bank debt
requires that ®rms extract larger surpluses from the owners of inputs, or that
they use inputs more intensively through productivity growth. Using pro®ts may
thus be hampered by mutually inconsistent distributional plans of ®rms and
owners of inputs, rigidities to productivity growth, and slow business activity.
When pro®ts are constrained by any of these factors, the ®rms' demand for
liquidity driven by interest debt service requirements needs to result in equity
transfers from the ®rms' original owners to the banks and/or the public. A
market for corporate control may evolve which may take various forms, de-
pending on the institutional characteristics of the economy involved: where
banks dominate the ®nancial system (and are not prohibited from owning
shares), corporate ownership claims tend over time to accumulate in the bank
portfolios, with the claims likely being exchanged in exclusive (bilateral) set-
tings under noncompetitive and nontransparent conditions. On the other hand,
in economies with more market-based ®nancial systems, corporate equity would
be absorbed by the public, directly or indirectly (through institutional inves-
tors), in more competitive and transparent contexts.
The market for corporate control can also be in¯uenced by the business
cycle. By compressing corporate pro®ts, economic slowdowns and recessions
likely generate preferences for noncompetitive transfers of ownership from
®rms to banks, since exclusive bank±®rm relationships make it relatively easier
and cheaper for both to convert debt into equity within the same bank port-
folios. With sustained economic activity, however, larger corporate pro®ts and
the public's greater appetite for risk and need for risk diversi®cation should
encourage transfers of ownership to households, to other ®rms, and to non-
bank ®nancial institutions through competitive markets.
However, whether corporate ownership is prevalently transferred to the
banks or to the public has a dierent impact on the system's liquidity. If ®rms
transfer ownership to the banks, the interest debt is settled directly as debt is
exchanged for equity and no additional money is needed in the circuit to make
interest payments. On the other hand, if corporate ownership shifts to the
public and to nonbank (®nancial and non®nancial) entities, interest payments

need to continue to be made from the ®rms to the banks, requiring new money
to be injected in the system.
4.3. Policy implications
Bank money creation entails a forward-looking process that goes from credit
to output generation and debt settlement. To the extent that the money ad-
vanced as credit can be backed by real output ex-post, the economy gains
greater ¯exibility to mobilize real resources for production than if the new
credit had to be backed up upfront.
On the risk side, however, a system where banks create money is riskier than
if banks were to fully cover their credit. Because banks issue liquid liabilities to
®nance illiquid assets, they bear liquidity risks and can transmit their risks across
the economy. Governments introduce rules and policies to reduce such risks.
In doing so, policymakers need to resolve important risk/eciency tradeos.
Two issues are taken up in this section to assess how policy to reduce bank
risks interact with bank incentives to create money: the ®rst deals with payment
settlement rules, and the second discusses the recurrent proposal to narrow the
scope of banking.
4.3.1. Alternative payment settlement rules
Interbank credit in a circuit process allows banks to create the money
necessary to ®nance economic activity by supporting banks' mutual debit
positions arising from deposit transfers (payments). 28 Each bank must be
suciently creditworthy to get credit from the other banks and, in turn, must
be willing to extend credit to the others (if these are suciently creditworthy) as
deposits move across their books.
Dierent payment settlement rules may alter the cost for the banking system
to create money. Under correspondent banking arrangements, banks hold ac-
counts with their correspondents through which they clear (incoming and
outgoing) payments. Correspondents extend credit to their client banks and to
other correspondents through credit lines or overdraft agreements under preset
terms and limits. Up to these limits, correspondents commit to make good all
incoming payments from their clients, until new funds are credited to the client
accounts and overdrafts and credit lines are repaid. 29 The cost of money
28
Smith and Weber (1998) show, analytically and historically, the welfare superiority of
payment systems with interbank credit.
29
Assume that banks A and B hold correspondent accounts with one another and agree on
mutual credit lines. If A's borrower pays B's client out of his loan account, A runs a liability vis-a-
vis B. Bank A may ®nance its liability by drawing its credit line with B. The same B can do for its
payments to A. In fact, the two banks can create money up to the limit of their mutual credit lines,
with no central bank money involvement.
creation is determined by the speci®c types of interbank credit agreements. The

reciprocity of such agreements and the adoption of netting contracts between
correspondents can make the cost of interbank credit, and hence of money
creation, much cheaper than if banks were to settle their (gross) mutual obli-
gations in central bank money (see below in this section).
Under multilateral net settlement rules, banks are required periodically to
use central bank money to settle their multilateral net payment obligations
outstanding at the time of settlement. This requirement does not prevent banks
from using the interbank credit implicit in the netting arrangement to create the
money needed to ®nance transactions during the interval between settlement
cycles. In fact, net interbank debit (credit) positions may in principle be very
small, or even zero, and yet banks' mutual gross obligations could be as large
as necessary to satisfy deposit transfers of any size. Multilateral netting rules
thus provide an economically convenient way for banks to create money.
Under gross settlement rules, banks are required to settle each (gross) inter-
bank deposit transfer in central bank money. Gross settlement virtually elim-
inates settlement risk as well as the possibility of systemic transmission of the
failure of individual banks to settle. But this comes at a price. Recent studies
have focused on the eciency costs of gross settlement rules, 30 including
payment gridlock problems and suboptimal intertemporal consumption eects
(Kahn and Roberds, 1999).
The circuit approach suggests that gross settlement also reduces the banks'
power to issue money and makes bank money creation more costly to the
economy. Under gross settlement, banks can mobilize deposit claims to execute
payments only if they have sucient cover funds in their account with the
central bank. They thus need to possess enough reserves, or to borrow them
intradaily from the central bank, before issuing and transferring deposits to
each other. In the event that central bank intraday lending requires collateral,
this has to be raised by the banks at a cost and may also carry a considerable
opportunity cost. On the other hand, if the central bank does not require
collateral but charges penalizing interest rates, these would still impose an extra
cost on the borrowing banks. 31
As a result, the banks must either pre-accumulate more capital (for any given
volume of deposits to be mobilized) or curtail their overall lending since issuing
and mobilizing deposits cost more to them than under non-RTGS rules. 32
30
See Kahn and Roberds (1999) for a review of the literature and a contribution to the issue.
31
A bank could alternatively borrow reserves from other banks, but this option is not feasible
for the banking system as a whole which either holds enough reserves or has to borrow them from
the central bank.
32
Should the reverse hold, there would be a serious presumption that the central bank subsidizes
interbank lending under RTGS by not charging a high enough interest rate to protect itself against
credit risk.
These replace a regime where banks can create money by exchanging IOUs with
a cash-in-advance type of regime which necessarily imposes a tighter real re-
source constraint on money creation.
4.3.2. Narrowing banking

Risk reduction lies at the heart of the various narrow banking proposals
periodically recurring in the literature and the policy debate. These proposals
aim to remove liquidity and solvency risks from the banking business by re-
quiring banks to fully back their demand deposit liabilities with safe short-term
assets. 33 The advocates of this approach note that the magnitude of such
assets outstanding outside the banking system exceeds the magnitude of banks'
demand for deposit liabilities. They read this as evidence of a large unsatis®ed
demand for safe assets that banks do not match because of existing distortive
incentives (such as deposit insurance, government regulation, or bailout
commitments), which encourage banks to hold illiquid portfolios (Kareken,
1985). They conclude that narrowing the scope of banks would correct these
distortive incentives.
In fact, one should wonder if the narrow banking approach would not
suppress the very function of banking. Wallace (1996) shows that narrowing
banks would eliminate the role of banking altogether. Such conclusion is re-
inforced by circuit analysis. If banks create money through lending to ®nance
production, a high leverage (or a fragile capital) is intrinsic to their incentive
structure whereby the liquid debt claims created stand necessarily against the
less liquid assets ®nanced.
Under narrow banking, banks cannot ®nance production. But then: How
would money be injected in the economy? How would production be ®nanced?
What would be the net social welfare impact of ®nancing production dierently
than under conventional banking?
One way to ®nance production under narrow banking would be through
specialized nonbank ®nancial intermediaries. These do not issue deposits and
do not have access to interbank lending. The central bank injects money in the
system through open market operations. The nonbanks borrow or purchase
money from the central bank against collateral or in exchange for securities,
and onlend it to the ®rms. In this case, the capital requirement to ®nance
overall nonbank lending would obviously be much higher than for banks that
can lend by issuing deposits.
33
For an analysis of the issue of narrow banking, see Bossone (2001b).
Alternatively, nonbanks and investors buy short-term securities from the

producing ®rms. In the absence of liquidity transformation from conventional
banks, such type of ®nancing requires lenders to willingly hold larger shares of
relatively less liquid claims than deposits. Unless this happens, either some
®nancing plans go unful®lled or new money has to come from the central bank,
with the same extra costs as above. In fact, there would always be a natural
incentive for conventional banking to emerge which narrow banking regulation
would simply suppress.
This suggests that regulations aimed to transform all banks into narrow
banks would create market incompleteness problems and increase the cost of
providing money to the economy. On the other hand, however, nothing should
prevent narrow banks from operating alongside conventional banks in re-
sponse to a market demand for safe assets.
5. Banks: A species in extinction?
This question arises spontaneously after observing that almost everywhere

in the industrial world, over the last two decades, traditional banking (deposit/
lending) activities have lost important market shares. Such loss is the result of
the impressive growth of commercial paper markets and the money market
mutual funds thrift industry, the increasing ownership of banks by securities
®rms and commercial enterprises, and the proliferation of quasi-monies or
money substitutes oering transaction services comparable to bank deposits.
Correspondingly, banks have had to diversify their activity from traditional
deposit/lending to nonbank intermediation and ®nancial services provision. 34
As many believe, the quantitative loss re¯ects a qualitative change: tradi-
tional banking has lost importance vis- a-vis other forms of ®nancial inter-
mediation. Banks as we have come to know them, it is argued, will either
disappear or become practically indistinguishable from other ®nancial insti-
tutions.
Is this necessarily so?
The following discussion argues that in the foreseeable future banks will
retain their special function, as de®ned in this study, irrespective of (and, in-
deed, owing to) the signi®cant structural changes that are taking place in the
market for banking and ®nancial services.
34
For an analysis of the decline of traditional banking in the US, see Edwards and Mishkin
(1995). Arestis and Howells (1999) and Howells and Hussein (1997) provide evidence for the UK.
For a recent international analysis and interpretation, see Allen and Santomero (2001l).
5.1. Nonbank ®nance and the relevance of banking
In the industrial world, nonbank ®nancial intermediaries have taken away

considerable business from commercial banks. Increases have been observed in
the market share of institutions holding securities instead of loans. At the same
time, banks themselves have heavily shifted their activity from traditional
banking to other ®nancial intermediation services. Lending to production, in
particular, has become less important as more and more ®rms can directly
access the market for short-term funds. Also, following ®nancial liberalization,
domestic banking sectors have undergone large reorganization, with banks
consolidating into fewer and larger units.
An interesting interpretation of the disintermediation problem is the core-
deposit theory of Berlin and Mester (1996). Liberalization has led banks to pay
market rates on an increasing portion of their funds, core deposits have
shrunk, and relationship lending has become less and less feasible. Accord-
ingly, banks have lost some of their comparative advantage vis-a-vis nonbank
intermediaries. 35
Circuit theory suggests an alternative hypothesis to explain disintermedia-
tion and consolidation. As liberalization reduces the demand for core deposits,
banks tend to run increasing interbank open debit positions associated with
their lending. As a result, banks incur higher reserves holding costs to protect
themselves against the risk of defaulting on interbank obligations. 36 This puts
pressure on banks to reduce lending and/or to expand their scale in an attempt
to capture a larger deposit base from competitors.
In any case, banks seem bound to become less in number and bigger in size.
But: can one imagine a world where nonbank intermediaries replace banks
altogether?
Aside from the arguments discussed earlier under the narrow banking ru-
bric, pointing to the real cost of money creation, there are important additional
factors to consider in answering this question. In an environment where bank
lending to production is less relevant, banks perform their key money creation
function through alternative (and more wholesale type of) instruments. These
include credit to nonbank intermediaries (including credit card issuers and
industrial corporations oering ®nancial intermediation services) and contin-
gent credit.
35
The concept of core deposits must be used cautiously. In a circuit process, increases in the
interest elasticity of the demand for deposits do not imply destruction of existing deposits, but
simply their increasing velocity of circulation. In principle, to the extent that banks extend sucient
credit to each other, and/or that their size allows them to minimize interbank exposures, the decline
of core deposits should not upset lending.
36
Larger reserves holdings are also needed in those systems using RTGS rules, as discussed
earlier.
By lending to nonbank intermediaries, banks indirectly supply the economy

with fresh money to absorb production and services. This is typical of bank
lending to intermediaries that provide credit for consumption, second-hand
asset purchases, and ®nancial services (including for speculation and hedging).
This credit is essential as industrial productivity growth requires ways to ex-
pand and accelerate consumption of durables and physical capital renewal, and
the demand for ®nancial investment and risk- and portfolio-management
services increases rapidly. Banks advance short-term loans to the intermedi-
aries with ready and deep access to the capital market. The intermediaries
onlend the loan proceeds (on longer-term conditions) to households and ®rms
planning to buy durables, second-hand assets, or ®nancial services. As sales are
executed, selling ®rms can encash the sale proceeds and invest the income,
which generates capital market funds. The intermediaries can re®nance their
position from the capital market and match their asset±liability maturity, and
the system overall has more liquidity in it. A new ¯ow of funds takes place
wherein the selling ®rms are the net savers (investors), the buyers of goods and
services are net disservers (fund users and borrowers), and banks remain the
suppliers of money.
Banks are thus essential for a growing real and ®nancial economy.
Banks create money also through contingent liabilities (such as guaran-
tees and warranties) that they issue to protect ®nancial and non®nancial in-
stitutions against contingencies that could disrupt their solvency. These
liabilities are stand-by commitments to issue money to their holders if and
when those contingencies happen. Their diusion con®rms the continuing
specialness of banks: ®rst of all, they enable the economy to use the existing
liquidity more eciently by supporting the extension of quasi-money and
short-term borrowing instruments to an extent that would not be feasible
without banks' stand-by commitment guarantees. Second, through these types
of liabilities banks act as backup sources of liquidity for all other institutions
in the system (Corrigan, 2000), and are in a position to support circuit closure
in the event of payment failures. This underscores the banks' continuing im-
portance in spite of the historical decline of their traditional activities. It
also emphasizes their key role as market agents specialized to validate the
creditworthiness of issuers of quasi-monies and short-term borrowing instru-
ments.
Through money creation banks complete the economy's ®nancial market
structure by transforming liquidity and maturity (at a risk). Although ®nancial
market development enables the economy increasingly to economize on bank
money through money substitutes, until the public becomes willing to bor-
row such substitutes and use them for payments, banks will remain special
and irreplaceable. Using money market mutual fund shares as an example of
quasi-money, Box 1 shows why they are not actually quite like bank deposits
yet.
Box 1 Are mutual fund shares real money?

Money market mutual funds pool savings from many individuals and
invest them in high-grade, short-term securities oering market returns on
share accounts that permit check writing and wire funds transfer privi-
leges. Although providing shareholders with deposit-like transaction ser-
vices, a close inspection at money market mutual funds shows that they do
not make banks and their money creation function any less special. First,
when mutual funds issue shares, they receive bank deposits that they hold
with their bank or banking department: deposits are not replaced by mutual
fund shares, but move from individual to mutual fund portfolios. Second,
when mutual funds buy securities, they sell deposits that securities issuers
use to ®nance their spending plans: deposits are not replaced by mutual
fund shares to ®nance spending plans. Third, when a shareholder instructs
her mutual fund to make a payment on her behalf to a third party, the
mutual fund debits the shareholder's share account and transfer equiva-
lent deposits from its own banking account to the third party: deposits are
not replaced by mutual fund shares as transaction devices, and payments
continue to be executed as deposit transfers on the books of banks. Of
course, the mutual fund can ®nance its payment obligations through a line
of credit from its bank or by liquidating its own securities. Both options,
however, involve deposit transfers: mutual funds do not create money, they
only transfer it from investors to users.
Mutual funds with many shareholders allow investors to economize on
bank deposits, as banks do with central bank money. This reduces the
total stock of deposits in the economy and increases their velocity of
circulation. But banks stand ready to purchase securities from mutual
funds (against deposits) if the event of liquidity shortfalls: banks are
backup sources of liquidity for mutual funds.
Finally, nothing in principle prevents the public from accepting mu-
tual fund shares as payment instruments. In this case: mutual fund
shares would become full-¯edge money and, like banks, mutual funds
would have an incentive to lend to the public by issuing new shares. This
would make them special (i.e., money creators) and public pressure would
likely step up to place them under banking-type regulations and safety
nets.
5.2. E-money: A glance at the future
The concept of e-money used here refers exclusively to computer money

forms that represent liabilities of nonbank entities or of special segregated bank
accounts, and substitute for conventional monies. It rules out all instruments
introduced to move around bank money more quickly, such as home banking,
electronic bill paying, ETF, and ATMs. 37
E-money is initially issued to clients by network operators on network ac-
counts, in exchange for conventional bank deposits. The e-issuers now hold the
original bank deposits, which are perfectly matched by what they owe to their
clients. Assuming full acceptability of the new money instrument and full
trading security, the e-money is used by shoppers to ®nance purchases online.
Merchants are paid in e-money and convert their e-receipts into conventional
bank deposits. Accordingly, their bank accounts are credited while shoppers'
bank accounts are drawn down equivalently.
At some point, the e-issuers may start oering e-deposit facilities, so that
merchants can either hold their e-value with the issuers, or use it for further
payments in the net. This could extend to other payers and payees along the
trade chain. Thus, once issued, the e-money stock could in principle never
return to the conventional banking system; it could become an inde®nite
leakage for it and grow independently of it.
Are banks to disappear in this scenario? Quite the opposite. Even though
individual banks might be unable to make it in the new world, banking as such
would still be there under new a guise. As the new e-deposit becomes accepted
in the system, some e-issuers would face an incentive to move away from fully
(conventional) deposit-backed e-money, and start using the ¯oat to make
e-loans. Further down the road, as the size of the e-issuers grows and their
reputation consolidates throughout the network community, they would have
an incentive to lend e-deposits: History would repeat itself. Growing bigger
would give individual entities a larger capacity to intermediate e-deposit
transfers and, hence, to create e-money.
Conventional banking would be replicated. Any nonbank entity aiming to
take deposits, make loans, and manage payments online would have to possess
much of the same skills that bankers have developed for centuries. E-banks
would still be special: they would create e-money by lending their own e-debt.
What is the prospective role of banks and intermediaries in the age of
electronic money? Will both lose ground to direct ®nance as investors and fund
users are less and less inhibited by time, space, and information constraints to
meet one another directly in the e-market arena?
The age of electronic money is the age of rapid progress in communica-
tions and information technology that allows more and more individuals to
interact in the markets. As technological development proceeds, the options
and opportunities available to investors continue to grow, while transaction
37
For an extensive and still fresh discussion of the various issues relating to e-money, see
Solomon (1997).
costs decline further. This is not inconsistent, though, with anticipating that
the demand for both banking and nonbanking services will increase in the
future.
First, the openness and speed of the e-world generate larger networks where
the number of possible contacts and choice options grow manifold. This is
what creates opportunities. However, it is also where the impossibility for in-
dividual network nodes to know each other comes as a strong limitation to
direct transactions. Large networks exacerbate the individuals' problem to
overcome mutual distrust, especially in the face of complex transactions and
risks. No matter how much information is available to establish mutual trust-
worthiness and to assess risks, the information is hard to collect, assemble and
elaborate. It requires time, resources, and skills. And, by the way, how can one
be sure that the information is reliable and its source trustworthy?
Second, transacting through networks requires that traders trust the net-
works ± that is, their infrastructure and governance structure. Who's going to
bridge across the trust gaps? How can societies bene®t from the new techno-
logies in the presence of large trust gaps? There are basically two types of in-
stitution that will be key to make networks expand and consolidate. They are,
again, the banks and the nonbank ®nancial intermediaries, with specialized and
not-so-new-after-all tasks to perform each.
5.2.1. Banks
The quality and cost of the money created and allocated to the private sector
to ®nance production and consumption will continue to depend on the banks
and their risk management capacity. The need to preserve the banks' power to
create money eciently will likely mitigate the current trend toward RTGSs,
and will presumably push back the re-introduction of correspondent banking
and netting arrangements (strengthened as necessary to deal with systemic
risks), or it will lead to some hybrid arrangements (McAndrews, 1997). On the
other hand, in a world where trust gaps are relevant, money creation will re-
quire issuers with high reputation and strong business commitment.
These two circumstances will prompt banks to compete to attain larger size
and market shares. Size will matter in two respects. First, in a competitive ®-
nancial environment where the high velocity of money and the wider range of
quasi-monies make core deposits less attractive to investors, a large deposit
base will be necessary for banks to extract rents from money creation via
lending and payment intermediation. Second, only large and highly visible
private banks (or large clearinghouse arrangements among smaller banks)
will be able to accumulate enough reputational capital to attract depositors'
trust: the more money will be immaterial, the more people will want to know
who produces it. Large size and a large capital base will be crucial in both
respects.
The visibility that banks will earn in the market as trustworthy institutions
will also be crucial to reduce their costs. Since the use of costly bank capital as
a reputation signaling device involves signi®cant economies of scale (Hughes
and Mester, 1998), in a world where reputation matters more banks will have
one more incentive to reach for larger sizes directly or indirectly by joining
others in large clearinghouse arrangements.
All in all, whereas banking ± as de®ned by circuit theory ± will likely
maintain (and even enhance) its core role as circuit starter, it will become a
much more consolidated business.
5.2.2. Financial intermediaries

In a network-based world where managing trust gaps and information
processing are essential tasks, nonbank intermediaries are integral to the net-
work infrastructure and provide the seal of trust necessary for individuals to
use the networks with con®dence. More and more in the future will ®nancial
intermediaries combine communications, information, and ®nancial knowl-
edge to supply agents with secure exchange mechanisms. They will process the
information needed for anonymous individuals to enter deals with each other
and to manage information-intensive ®nancial instruments. Through their re-
putational and knowledge capital, they will oer certi®cation services to vali-
date the quality of the information used.
Such capital will also be useful for the intermediaries to perform risk ag-
gregation and diversi®cation functions that cannot be performed by individual
agents, or that may be too costly for individuals to perform. Intermediaries will
therefore be instrumental to lowering participation costs of individual agents to
large and complex markets.
In short, although in the future the circuit process will look increasingly
sophisticated, its basic banking and ®nancial functions will remain funda-
mental and fundamentally the same. Banks and nonbanks will become in-
creasingly important as individuals take a more active role in saving and
investing.
5.2.3. Less banking, more nonbanking

In the early stages of development, economies are characterized by poor
®nancial infrastructure. Transaction costs are prohibitive for individuals and
for nonbanks to engage in investment ®nance and to manage diversi®ed port-
folios. In such a context, banks ®ll the gap between investors and fund users
more eciently than other intermediaries, due to their peculiar relationships
with the borrowers. Through such relationships, banks supplement the lack of
®nancial infrastructural services in a number of ways. They can have exclusive
access to information on the borrowers, they can exert leverage enough to
reduce risks of asset substitution, moral hazard, and poor loan performance,
and they can liquidate assets of defaulted borrowers at better terms. All this
grants banks with a rent-extraction power which they use to attract liquidity
from depositors in exchange for a credible promise to transfer back to them a
share of the rents extracted from borrowers.
To the extent that the e-age brings more developed infrastructure, the banks'
quasi-monopoly of information is removed and information is no longer re-
stricted within their exclusive relationships with borrowers. As a result, the
value of the ®rms becomes known to the market and the banks' comparative
advantage declines: banks tend to lose market shares vis-a-vis nonbanks. They
therefore try to extend their activities into the nonbanking ®nancial sector and/
or seek to expand their size to increase gains from seigniorage. Since stronger
competition in the nonbanking sector erodes pro®t margins for nonbanks,
these too have an incentive to merge or acquire banks to add seigniorage rents
to their income. Overall, this results in a consolidation of the banking sector,
leading to less and larger units.
6. Conclusion
Over the last two decades, the literature on the theory of ®nance has oered
signi®cant contributions to the understanding of the role of banks in market
economies. Various contributions have sought to identify speci®c aspects of
banks that qualify them as special intermediaries, including liquidity and
payment, credit, and information services, for the provision of which they have
historically developed comparative advantages. But the evolution of ®nance,
through greater market competition, technological progress, and institutional
development, has progressively eroded the comparative advantage of banks,
whose once peculiar functions can nowadays be performed as eciently by
nonbank ®nancial intermediaries. As many foresee, also, the future success of
e-money might deal a fatal blow to conventional banking and generate entirely
new ways of doing ®nance.
This study has inquired into the nature of banks. It has argued that banks
are special in so far as they, only, can lend claims on their own debt which are
accepted and used by the public as money. This power grants banks a unique
role in the economy. As money creators, they are irreplaceable by nonbank
intermediaries, even though new ®nancial instruments feature deposit-like li-
quidity and payment services.
This study argues that the specialness of banks will survive in the e-age. As
one recognizes banks as being more than mere intermediaries, banking appears
set to remain a much needed technology, notwithstanding the transformation
that money may undergo over time as a vehicle of purchasing power. And in so
far as technological progress speeds up the velocity of money circulation, the
incentive to issue money through lending and by managing payments may
increase manifold in the e-age, carrying with it problems of poor credit quality
and money overissue and, most of all, raising unreassuring prospects that any
nonbank entity may try to act like a bank.
If the arguments of this study are at all convincing, one might conclude
that the e-age will not add much, after all, to what is already special about
banks, although, of course, new forms of money will bear new practical and
policy implications. Irrespective of its technological supporting infrastructure,
bank money has always been ``virtual'' as it has always rested on promises
issued by entities specialized in attracting public trust. Any step ahead into the
e-age will only be a rearmation of the inherent and attractive virtuality of
money.
Acknowledgements
Banca d'Italia and International Monetary Fund. I am intellectually in-

debted to Prof. A. Graziani, for his seminal work on monetary circuit theory.
I wish to thank T. Beck, J. Hanson, P. Honohan, A. Giustiniani, R. Levine,
F. Mishkin, L. Promisel, and the anonymous referees for their most valuable
comments. Of course, I am the only responsible for any remaining errors in the
text and for the opinions therein expressed, which do not necessarily re¯ect
those of the institutions named above. Last, but by no means least, I wish to
thank my wife Ornella for her unremitting loving support.
Appendix A. The circuit model: An illustration
This appendix describes the circuit process of banking and ®nance with the
help of the formal model developed in Bossone (2001a) and here further im-
proved on. The model is for illustrative purposes only; it is not used to show
equilibrium properties or to derive the impact of parameter changes, but only
to provide a framework to make explicit the agents' dierent roles and in-
terrelationships. In the model below, the choice-theoretic assumptions used
are standard, and prices are taken to exist at which the economy's real and
®nancial equilibrium conditions are de®ned. All monetary variables are ex-
pressed in nominal terms, and relative prices are assumed to be constant
throughout the circuit cycle. The agents behave as follows:
A.1. Households
ch cyhe ; rL ; rS ; c0y > 0; c0r < 0; A:1
sh wh ch CRh rS ; A:2
sh szh 1 zh ; A:3
zh zrL ; rh ; 0 6 z 6 z 6 1; z0r > 0; z0r < 0: A:4
Households supply labor services to ®rms and receive wage income w. Their
labor supply is linear in leisure and thus varies proportionately with income.
They aim to smooth intertemporal consumption, based on expectations of
lifetime income and have access to bank credit. Consumption c is positive in
permanent income y e and negative in the return on ®nancial wealth rL and in
the bank lending rate rS (Eq. (A.1)). Saving is current income minus con-
sumption and debt service (Eq. (A.2)). Households invest a share z of savings
in securities purchased through ®nancial intermediaries, and hold the re-
maining share as transaction deposits at banks (Eq. (A.3)). Share z is positive
in rate of return rL and negative in income variability r (Eq. (A.4)); however, z
can be bounded from above (z 6 z ) if ®nancial intermediaries ration their
supply of investment funds (see below) and, correspondingly, their demand for
savings.
A.2. Firms
X
w wh mcS I S ; 0 < m 6 1; A:5
h
cs 6 Ecd ; A:6
I s 6 EI d ; A:7
I d I d l rL ; I 0 > 0; A:8
l lK0 I; l0 < 0; A:9
yf I c w; A:10
c mincs ; cd ; A:11
I minI s ; I d ; A:12
yfn I c CRf 1 rS : A:13

Production costs are a share of the total production value of consumption
and capital goods, c and I respectively (Eq. (A.5)), where m can be thought of
either as a distributional parameter or as re¯ecting the value added from
production. The production technology of f has constant returns, implying
that the ®rm's pro®ts vary linearly with production. Firm f seeks to maximize
pro®ts. The supply of goods is based on and adjusts instantaneously to ex-
pected demand (Eqs. (A.6) and (A.7)), though bank credit rationing may cut
supply short of expected demand (see below). With supply adjusting to de-
mand, the interest rate determines the allocation of resources (from the
households) to current and future consumption. The demand for capital good
increases with the dierence between marginal capital eciency l and cost of
funds r de®ned below; l is decreasing in aggregate capital K consisting of in-
herited capital plus new investment (Eqs. (A.8) and (A.9)). Corporate gross
income of f is given by output sales minus total wages (Eq. (A.10)). Actual
sales of c and I are the least of their respective market demands and supplies
(Eqs. (A.11) and (A.12)). Net corporate income yfn is revenue minus gross debt
payments (Eq. (A.13)), equal also to gross income minus interest debt pay-
ments. If yfn is negative, the circuit closes only if ®rms borrow new money, or
manage to have their old loans rolled over, by the banks. Any positive yfn is
saved (see Eq. (A.22)).
A.3. Banks
X X
CRs CRsb CRb rS w; CR0 > 0; A:14
b b
w wCRs ; rS ; wCR > 0; wr > 0; A:15
CRs CRn CRf ; A:16

X
CR D Db ; CR 6 CRs ; A:17
b
X
CRsb Db 6 Kb CRBb ; B 6 b; A:18
B
yb rS 1 w CRsb ; A:19

s
In Eq. (A.14), the supply of loans CR to ®nance input acquisition and
output sales is positive in the dierence between the price of the loan rS and the
default risk of the borrower w. The latter varies directly with both the amount
and the price of the loan (Eq. (A.15)). The bank and the borrower negotiate rS ,
and the bank sets CRS where rS equals the borrower's marginal risk of default.
The bank seeks to strike the loan price which maximizes its risk-adjusted
pro®ts at the optimal level of lending. The amount lent to households and ®rms
determines f 's maximum output sold in the market.
Total bank deposits equal the stock of credit outstanding CR at all times of
the circuit period (Eq. (A.17)): ®rst, all deposits equal credit issued at circuit
start (see above). Second, if all deposits are used to purchase goods from the
producing ®rms, the latter appropriate the money borrowed initially and payo
their bank at circuit end, so that CR D 0 in Eq. (A.17). Third, if a positive
stock of deposits are held on bank accounts, corporate incomes are reduced
equivalently causing an equal stock of loans to default and to remain out-
standing at circuit end, i.e., 0 < D=CRs CR=CRs 6 1. If bank b's loans ex-
ceed the deposits held on its accounts as a result of deposit transfers to other
banks, b needs to ®nance the balance; it P can do so by using its own capital Kb
and/or by borrowing from other banks B CRBb (Eq. (A.18)). 38
No cash circulates in the economy and all payments consist of deposit
transfers across bank accounts (book entries). As banks extend credits to each
other, issuing loans does not entail central bank (reserve) money transfers be-
tween banks, unless and until the banks receiving deposits against the new loans
require issuing banks to settle their debt in reserve money. Deposits are de-
stroyed (and liquidity withdrawn from the system) when loans are repaid to the
banks.
At circuit end, the banks receive debt payments from the borrowers. If some
borrowers are unable to payo their debt, banks decide whether to renew (or
rollover) their original loans to them. Eq. (A.19), where w is the ex-post rate
of default on bank debts, de®nes bank income as the interest earned on actually
repaid loans. Bank income is invested in the capital market (Eq. (A.22)).
A.4. Nonbank ®nancial intermediaries
LFd I d ; A:20
X X
LFs sh zh zj yj 6 S; A:21
h jf ;b;F
X X X X
S sh yfn yb yF ; A:22
h f b F
38
To keep the model simple, banks here do not remunerate deposits and have access to
unlimited and costless interbank lending. Absent such assumptions, any bank aiming to increase its
lending can oer a competitive return on its deposits and expand its deposit base. The assumption
above emphasizes the role of interbank lending in supporting bank money creation.
LFs LFs r; r ; LFr R 0 if r Q r ; A:23
r rL q; A:24
rL rL LFd LFs ; r0 > 0; A:25
r r /rmax ; /0 > 0; /00 > 0; A:26
yF qLF; A:27
LF minLFs ; LFd : A:28

The demand for capital good I thus generates a demand for nonbank loans
LF (Eq. (A.20)). The ®rst equality in relation (A.21) indicates that the supply of
funds from nonbanks equals their aggregation of long-supply of long-term
savings (as de®ned by Eq. (A.22)); the possible inequality between the last two
terms of Eq. (A.21) indicates that the supply of long-term funds may fall short
of aggregate saving, due to rationing behavior. The latter may result either from
nonbanks deliberately borrowing less than what investors are willing to invest
(owing to risk considerations), and hence intermediating less than the aggregate
funds available, or from investors having a higher liquidity preference. 39
Nonbanks supply funds until the price they charge reaches its risk-adjusted
maximum level (Eq. (A.23)), where the risk-adjustment factor is a convex
function / of r (Eq. (A.26)). Nonbanks charge a competitive intermediation fee
q on the interest rL that they pay to households on one side and pass on to the
borrowing enterprises on the other (Eq. (A.24)). Interest rate rL is determined
by the supply and demand for funds (Eq. (A.25)). Nonbanks earn income yF
(Eq. (A.27)), which they fully save. 40 The investment actually funded in the
economy is the least between the supply and demand for long-term funds (Eq.
(A.28)).
Assuming equilibrium prices exist, the real and ®nancial conditions for
equilibrium are, respectively:
X X
cs I s ch I d yj A:29
h jh;f ;b;F
where producers sell all their output and investing enterprises raise enough
funds to settle their contract obligations with capital goods producers, and
39
On the household side, this corresponds to actual z's being upper bounded by z 's in Eq. (A.4).
40
The proceeds of the nonbank ®nancial institutions should in fact partly feed into payments for
inputs used in intermediation activity, while only pro®ts could be retained as savings. However, as
the income of input suppliers would have the same destination of corporate income, those proceeds
may be left out of the model without loss of generality and no result alteration. For the same
reason, commercial banks are assumed not to bear production costs.
CRs 1 rS LF c A:30
requiring that at circuit end all deposits are destroyed, all money incomes are
spent in consumption and investment, and borrowers payo their debt. As
noted in Section 3.1, at circuit end the producing ®rms ± as a group ± can
appropriate no more than the money originally injected in the system. This
equals the initial bank loans and does not include the money needed to pay
interest debt. Thus, the producing ®rms may at most be in a position to payo
the principal of their debt to the banks, while they need additional money to
settle their interest debt. Injection of new money and conversion of short-term
interest debt obligations into longer-term obligations are necessary to allow
®rms to payo their initial bank debt discusses the conditions for allowing
interest debt payments and circuit closure. 41
In equilibrium: banks advance the credit needed by ®rms to produce at their
maximum capacity consistent with their debt service capacity; ®rms formulate
correct expectations as to the demand for consumption and capital goods;
households supply all labor necessary for the ®rms to support production, and
use income and credit to optimize intertemporal consumption; ®nancial in-
termediaries allocate all savings from investors to investing enterprises.
Note that the model above is ¯exible in that it can incorporate dierent
behavioral assumptions. Changing such assumptions helps identify points
along the circuit where the money ¯ow may slow down or even break down
causing micro- and macro-imbalances (Bossone, 2001a). Changing the as-
sumptions may thus alter the volume and direction of the funds transferred in
the economy and, hence, the accumulation of stocks; but it would not alter the
fundamental sequential nature of the economy captured in the model whereby,
invariably: (i) the banks are the circuit starters (owing to their power to create
money), (ii) savings originate from investments, and (iii) the nonbank ®nancial
intermediaries allocate the existing liquidity to fund users.
Appendix B. Transaction eects on the agents' balance sheets in the circuit

process
This appendix illustrates with an example the changes that take place in the
balance sheet of each agent acting in the circuit sequence described in Section
3.1. Each transaction generates fund transfers that changes the asset and lia-
41
The sequence would be: banks lend short term to ®rms ! ®rms pay interests ! banks receive
interest income and invest it in the capital market ! ®rms borrow from the capital market and
clear-o the bank debt ! the newly created money re-¯ows to the issuing banks and is destroyed.
Thus, as banks inject fresh money, ®rms can convert their short-term interest debt obligations into
long-term liabilities through the ®nancial market.
bility composition of the balance sheets. The numbers in parentheses indicate

the place of each transaction in the sequence.
The items in the shaded areas indicate transactions initiated by the agents.
All agents start with zero asset and liability stocks. At circuit end, stocks ac-
cumulates as a result of net ¯ows. Firm F holds deposits at bank A; household
H holds deposits at bank B and securities deposits with nonbank intermediary
I; this holds deposits at bank B. Firm F produces consumption and capital
goods and repays its debt to A using the proceeds from sales to H and (long-
term) borrowing from I. At circuit end, the position of all agents is balanced,
and the economy has generated new savings and investments that add to the
existing stock of ®nancial wealth and physical capital, respectively. Note that if
H were to hold bank deposits at circuit end, F would not be able to payo its
debt to A, and A would have to either rollover its credit to F or write o the
loss.
Bank A creates deposits by lending to F, while nonbank I only transfers
bank deposits from household H to F by mobilizing its account at bank B. The
two shaded areas in A's balance sheet denote that money is an asset±liability
created as a loan is issued to F. Lending to F entitles it to an equal deposit
claim on A that F can use to ®nance its spending plans. To the extent that the
use of such deposit claim by F generates transfers of monetary value from A to
B, credits from B to A are necessary to support the claims transferred.
In a model where deposit transfers have to be backed by central bank
money, bank A can start operating only if it has the capital to buy/borrow
central bank money.
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Do Banks Have A Future

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Journal of Banking & Finance 25 (2001) 2239±2276

Do banks have a future?

1. Do banks have a future?

Progress in ®nance seems largely to coincide with a lesser role of traditional

2. Why banks are special: A review of the literature

The specialness of banks has traditionally been traced to the monetary

means of exchange and payment on the basis of a ®duciary relationship among

2.1. The credit function

Diamond (1984) ®nds a special feature in banks acting as delegated moni-

What is characteristic of bank loans is that their value is ®xed in nominal

monopolistic) rents. 6 As relationships consolidate over time, it becomes costly

2.2. The liquidity function

The credit view of bank specialness underscores the relevance of banks'

2.3. Integrated functions

Fama (1985) points to the specialness of banks as deriving from integrating

3. Why banks are special: The circuit approach

Integrating bank credit and liquidity functions, as proposed by the theo-

Appendix A describes the circuit process through a formal model. The

Fig. 1. Flow of funds in the circuit model.

4. Implications of the circuit approach

4.1. Why banks are special

When the economy is considered in its sequential stages as in the model

4.2. Structural implications

4.2.1. Bank extract seigniorage

4.2.2. Banks tend to accumulate corporate ownership and control

public and to nonbank (®nancial and non®nancial) entities, interest payments

4.3. Policy implications

creation is determined by the speci®c types of interbank credit agreements. The

4.3.2. Narrowing banking

Alternatively, nonbanks and investors buy short-term securities from the

5. Banks: A species in extinction?

This question arises spontaneously after observing that almost everywhere

5.1. Nonbank ®nance and the relevance of banking

In the industrial world, nonbank ®nancial intermediaries have taken away

By lending to nonbank intermediaries, banks indirectly supply the economy

Box 1 Are mutual fund shares real money?

5.2. E-money: A glance at the future

The concept of e-money used here refers exclusively to computer money

5.2.2. Financial intermediaries

5.2.3. Less banking, more nonbanking

Banca d'Italia and International Monetary Fund. I am intellectually in-

Appendix A. The circuit model: An illustration

ch  c yhe ; rL ; rS ; c0y > 0; c0r < 0; A:1

sh  szh  1 zh ; A:3

zh  z rL ; rh ; 0 6 z 6 z  6 1; z0r > 0; z0r < 0: A:4

l  l K0  I; l0 < 0; A:9

yfn  I  c CRf 1  rS : A:13

w  w CRs ; rS ; wCR > 0; wr > 0; A:15

CRs  CRn  CRf ; A:16

yb  rS  1 w CRsb ; A:19

A.4. Nonbank ®nancial intermediaries

LFs  LFs r; r ; LFr R 0 if r Q r ; A:23

rL  rL LFd LFs ; r0 > 0; A:25

r  r / rmax ; /0 > 0; /00 > 0; A:26

LF  min LFs ; LFd : A:28

Appendix B. Transaction eects on the agents' balance sheets in the circuit

bility composition of the balance sheets. The numbers in parentheses indicate

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ch cyhe ; rL ; rS ; c0y > 0; c0r < 0; A:1

sh szh 1 zh ; A:3

zh zrL ; rh ; 0 6 z 6 z 6 1; z0r > 0; z0r < 0: A:4

l lK0 I; l0 < 0; A:9

yfn I c CRf 1 rS : A:13

w wCRs ; rS ; wCR > 0; wr > 0; A:15

CRs CRn CRf ; A:16

yb rS 1 w CRsb ; A:19

LFs LFs r; r ; LFr R 0 if r Q r ; A:23

rL rL LFd LFs ; r0 > 0; A:25

r r /rmax ; /0 > 0; /00 > 0; A:26

LF minLFs ; LFd : A:28

Appendix B. Transaction eects on the agents' balance sheets in the circuit