Risk sharing in a world with processing costs: Trading versus banking

We analyze the bank versus exchange problem in a Diamond Dybvig (1983) economy with exogenous transaction processing costs. We find that processing costs in the market enables the bank to overcome the side trade threat (Jacklin (1987)) and offer some desirable liquidity insurance. Moreover, in the bank equilibrium processing costs are proportional to consumption, while in the market economy early and late consumers incur equal costs. These two effects explain that for a given level of aggregate processing costs, the bank economy is superior. On the other hand, the number of transactions in the bank economy is larger. It is for this reason that if processing costs are proportional to transaction value, and independent of the mechanism used, the exchange economy is superior. © 2008 New York University Salomon Center, Financial Markets, Institutions & Instruments.