DP17770 Safety First: A Theory of Banking
We propose a safety demand view of banking. Households have a structural preference for safety and heterogeneous self-insurance options, and choose a portfolio of productive and directly control personal assets. Private intermediaries arise endogenously to limit inefficient self insurance, as households with high self-insurance returns invest in bank equity while households with low self-insurance returns hold debt. The conflict over interim risk choices is solved by demandable debt, forcing early liquidation. Our theory rationalizes puzzling empirical findings in household finance, such as large dfferences in risky returns across the wealth distribution. We show that public provision of safety can crowd in the private provision of safety, as safe public debt requires taxing safe income. In contrast, deposit insurance can boost both intermediation and productive investment.