Inside money, fraud and self-fulfilling liquidity dry-up

I study the efficiency of issuing inside money under the risk of fraud in a competitive equilibrium. In the model, bankers can issue money with their franchise values and/or by holding real assets, but they can also fake the quality of the asset at a proportional cost. When the supply of assets is scarce and the counterfeiting cost is intermediate, multiple equilibria can arise with a self-fulfilling liquidity dry-up, where the haircut in the collateral transaction increases and aggregate liquidity shrinks simultaneously. This equilibrium allocation is suboptimal because the individual bankers cannot internalize the effect of issuing money on the prices and the pledgeability of the assets in general equilibrium. We find that imposing an entry cost is more effective in correcting pecuniary externality because the counterfeiting incentive can be discouraged by a positive franchise value. Maximum haircut requirements have an advantage of eliminating a self-fulfilling liquidity dry-up.