Banks as Liquidity Multipliers.

This article develops a theoretical framework analyzing how banks use liquid assets—specifically high-quality liquid assets (HQLAs), such as government bonds—as inputs to produce demand deposits, which serve as private liquid claims, while simultaneously incurring liquidity risk. Using a global games model of bank runs with endogenous balance sheet decisions, the authors introduce and prove the existence of a liquidity multiplier, defined as the amount of deposits a bank can create per additional unit of liquid asset without increasing liquidity risk, and show that this multiplier is strictly greater than one when liquidity risk is positive. The theory explains banks' balance sheet choices, the pricing of liquid securities, and the role of public liquidity provision, concluding that banks hold the entire supply of government bonds in equilibrium and act as liquidity multipliers by transforming scarce public liquidity into a larger supply of private liquidity. The model also demonstrates that while increasing the supply of government bonds (public liquidity) always improves welfare if costless, it may raise systemic liquidity risk due to banks expanding their deposit issuance, and that the equilibrium allocation is constrained-efficient, with no private-social planner divergence in banks' liquidity and leverage decisions.