Competitive Bank Liability Design

We study how competitive banks design liabilities that function as money in an economy with asymmetric information. Assets differ in risk exposure, and sufficiently risky assets cannot circulate in decentralized trade. Banks commit to state-contingent payoffs and transform asset payoffs through bundling and tranching. In equilibrium, banks issue money as a liquid but risky liability that circulates in payments as well as an illiquid residual claim. Liquidity creation (i.e., money provision) relies on holding illiquid, risky assets and is enhanced by bundling safe and risky assets. Regulation of bank balance sheets should internalize these monetary provision and risk transformation roles.