In 2007, when Riksbank Committee awarded the Economics prize to Mechanism Design Theory, I realized there is something like this in economics.
Adam Smith’s classical metaphor of the invisible hand refers to how the market, under ideal conditions, ensures an efficient allocation of scarce resources. But in practice conditions are usually not ideal; for example, competition is not completely free, consumers are not perfectly informed and privately desirable production and consumption may generate social costs and benefits. Furthermore, many transactions do not take place in open markets but within firms, in bargaining between individuals or interest groups and under a host of other institutional arrangements. How well do different such institutions, or allocation mechanisms, perform? What is the optimal mechanism to reach a certain goal, such as social welfare or private profit? Is government regulation called for, and if so, how is it best designed?
And mechanism design helps in understanding these questions.
I came across this paper which analyses Banking using Mechanism Design. It is written by Fabrizio Mattesini, Cyril Monnet and Randall Wright.
The authors study banking using the tools of mechanism design, without a priori assumptions about what banks are, who they are, or what they do. Given preferences, technologies, and certain frictions – including limited commitment and imperfect monitoring – they describe the set of incentive feasible allocations and interpret the outcomes in terms of institutions that resemble banks. The bankers in the authors’ model endogenously accept deposits, and their liabilities help others in making payments. This activity is essential: if it were ruled out the set of feasible allocations would be inferior. The authors discuss how many and which agents play the role of bankers. For example, they show agents who are more connected to the market are better suited for this role since they have more to lose by reneging on obligations. The authors discuss some banking history and compare it with the predictions of their theory.
I couldn’t understand bulk of the paper as it is highly technical. But usage of mechanism design to study why banks exist sounded useful to me.
The paper says having a third agent take care of deposits makes it more credible that the parties will honor their transactions. This third agent resembles a bank.
An implication is that delegated storage may be useful: If you deposit your output with a third party who has less incentive or ability to liquidate it for strategic reasons, others are more willing to give you credit. Thus, claims on deposits can be used to facilitate transactions, and this resembles banking. This activity can be part of an e¢ cient arrangement even if the third party has an inferior storage technology. Thus, bank liabilities can be useful for payments even if dominated in return. Although other things being equal, it is obviously better if the bank has access to good storage or other investment opportunities.
We want to ask, however, why the third party is less inclined than you to renege on obligations. In our approach, future rewards and punishments mitigate strategic behavior, but monitoring is imperfect (opportunistic deviations are detected only probabilistically). Agents with a higher likelihood of being monitored have a greater incentive to make good on obligations and, hence, are better suited to take on the responsibility of holding deposits.
All these are features we assume to be associated with a bank. The authors however begin ignoring these assumptions about a bank. And arrive at these ideas using mechanism design theory.
November 9, 2009 at 7:22 pm |
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