“On the Number and Size of Banks: Efficiency and Equilibrium”

Angela Kui Huang, National University of Singapore

I develop a model where banking arises endogenously from economies of scale in monitoring. Only a fraction of agents are designated bankers, to reduce monitoring costs, but that implies more deposits per bank and therefore greater incentives to divert profits opportunistically. Hence, with fewer bankers, they need higher rewards. The optimal number of banks decreases with monitoring costs, impatience and the temptation to default, and increases with investment returns. To implement efficient allocations, there is a tension between free entry and the positive bank profits required for incentives. Therefore, equilibrium is optimal only if we limit entry by taxation or a quota on bank charters.