Liquid bank liabilities

In this paper, we study the manner in which banks design and issue liabilities that facilitate trade amongst their customers. A bank mitigates a lemon problem by offering ex-ante lines of credit to their customers. Ex-post, some of these customers find it optimal to use their line of credit by pledging and revealing private information about their collateral. In exchange, these customers receive a deposit-like bank liability, which they subsequently use as a means of payment. In the optimal banking contract, the bank remains opaque about the private information; the liability is less risky than the underlying collateral; and the bank uses its capital to absorb losses in bad states of the world. We show that, with multiple banks, liabilities circulate and are guaranteed by the assets of the banking systems. We find that negative shocks to collateral value may propagate in the entire banking system.