Modern Monetary Circuit Theory, Stability of Interconnected Banking Network, and Balance Sheet Optimization for Individual Banks

TL;DR

This paper develops a modern stochastic Monetary Circuit Theory, analyzes the stability of interconnected banks, and proposes a balance sheet optimization model, highlighting central banks' stabilizing role and network resilience.

Contribution

It introduces a stochastic Monetary Circuit framework, a novel default model for interconnected banks, and a multi-period optimization approach for bank balance sheets.

Findings

Banks are naturally interconnected through money creation.

The Extended Structural Default Model assesses network stability.

Balance sheet optimization can improve bank resilience.

Abstract

A modern version of Monetary Circuit Theory with a particular emphasis on stochastic underpinning mechanisms is developed. It is explained how money is created by the banking system as a whole and by individual banks. The role of central banks as system stabilizers and liquidity providers is elucidated. It is shown how in the process of money creation banks become naturally interconnected. A novel Extended Structural Default Model describing the stability of the Interconnected Banking Network is proposed. The purpose of banks' capital and liquidity is explained. Multi-period constrained optimization problem for banks's balance sheet is formulated and solved in a simple case. Both theoretical and practical aspects are covered.