Bank Credit and Money Creation on Payment Networks: A Structural Analysis of Externalities and Key Players

When a bank extends a loan, it grants the borrower deposits. The borrower's use of deposits as means of payment causes deposit and reserve outflows at the lending bank. The payees' banks gain reserves on the asset side of balance sheets and deposits on the liability side. Therefore, one bank's lending decision has spillover effects on other banks' liquidity and balance-sheet conditions through payments. In this paper, we model banks' lending decisions through a linear-quadratic game on a random graph of payment flows and structurally estimate the spillover effects using Fedwire data to quantify the payment-flow network. Payment network externalities reduce the average level of aggregate credit supply by 9% while amplify the volatility by 20%. We identify a small subset of banks that have a disproportionately large influence on aggregate credit supply due to their special positions in the payment-flow network.