Banks as Secret Keepers

Résumé

Banks are optimally opaque institutions. They produce debt for use as a transaction medium (bank money), which requires that information about the backing assets not be revealed, so that bank money does not fluctuate in value, reducing its efficiency in trade. This need for opacity conflicts with the production of information about investment projects, necessary for allocative efficiency. How can information be produced and not revealed? Financial intermediaries exist to hide such information; they are created and structured to keep secrets. For the economy as a whole, this can be accomplished by a separation in how firms finance themselves; they divide into bank finance and capital market/stock market finance based on how well they can be used to maintain information away from liquidity markets. Firms with large projects, risky projects or projects easy to evaluate are less likely to be financed by banks. ⇤