A minimal model of money creation under regulatory constraints

TL;DR

This paper introduces a minimal agent-based model of the interbank network that explains money creation, liquidity dynamics, and collateral reuse under regulatory constraints, providing insights into market stability and policy design.

Contribution

It presents a novel minimal model capturing endogenous money creation, collateral reuse, and network stability, useful for stress testing and policy analysis.

Findings

Excess liquidity arises from reserve and liquidity ratio interactions.

Collateral reuse increases with collateral scarcity.

The network exhibits a core-periphery structure and is more robust under stress.

Abstract

We propose a minimal model of the secured interbank network able to shed light on recent money markets puzzles. We find that excess liquidity emerges due to the interactions between the reserves and liquidity ratio constraints; the appearance of evergreen repurchase agreements and collateral re-use emerges as a simple answer to banks' counterparty risk and liquidity ratio regulation. In line with prevailing theories, re-use increases with collateral scarcity. In our agent-based model, banks create money endogenously to meet the funding requests of economic agents. The latter generate payment shocks to the banking system by reallocating their deposits. Banks absorbs these shocks thanks to repurchase agreements, while respecting reserves, liquidity, and leverage constraints. The resulting network is denser and more robust to stress scenarios than an unsecured one; in addition, the stable bank trading relationships network exhibits a core-periphery structure. Finally, we show how this model can be used as a tool for stress testing and monetary policy design.