Bank Capital, Loan Trading and Funding Liquidity Creation
In extant theories of why banks exist, banks originate and hold loans, and this skin in the game is essential for the provision of intermediation services. In reality, loans are traded in secondary markets, raising the question: does trading diminish the value of the bank's core intermediation service? Using a banking model in which borrowers face production output uncertainty and banks facilitate real investment by creating funding liquidity - they lend more than the entire initial endowment of the economy - we show that the answer is no. Output uncertainty affects the value of intermediation and hence liquidity creation, but not through the usual risk aversion channel. We show that more liquidity is created ex ante when there are more ex post states in which output is deposited with banks. Interbank loan trading enlarges the number of such states, thereby enhancing liquidity creation and the value of intermediation. Higher bank capital leads to more trading states and thus improves welfare in a novel way. Interestingly, the trading price is not a welfare-neutral market clearing mechanism - there is a socially optimal price that maximizes the banking system's funding liquidity creation. The unregulated competitive equilibrium does not achieve this price, leaving room for intervention, which may involve a Tobin tax on loan buyers that subsidizes sellers or a (selective) subsidy for buyers. Central bank loan purchases can also improve welfare