On the essentiality of banks

Abstract

We compare allocations sustained by credit with allocations sustained by bank notes (inside money) in a search model with decentralized trade and limited monitoring. We demonstrate that there exists a credit arrangement that is superior to inside money. However, in contrast with inside money, this arrangement is not robust to an expansion of trade that is not accompanied by an adequate increase in the degree of monitoring. Therefore, banks are essential when trade is intense and monitoring is limited. As a historical application, we argue that our model helps explain the origins of banking in Medieval and Early Modern Europe.