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Why do Banks Promise to Pay Par on Demand?

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  • Margarita Samartin
  • Gerald Dwyer

Abstract

We survey the theories of why banks promise to pay par on demand and examine evidence about the conditions under which banks have promised to pay the par value of deposits and banknotes on demand when holding only fractional reserves. The theoretical literature can be broadly divided into four strands: liquidity provision, asymmetric information, legal restrictions, and a medium of exchange. We assume that it is not zero cost to make a promise to redeem a liability at par value on demand. If so, then the conditions in the theories that result in par redemption are possible explanations of why banks promise to pay par on demand. If the explanation based on customers’ demand for liquidity is correct, payment of deposits at par will be promised when banks hold assets that are illiquid in the short run. If the asymmetric-information explanation based on the difficulty of valuing assets is correct, the marketability of banks’ assets determines whether banks promise to pay par. If the legal restrictions explanation of par redemption is correct, banks will not promise to pay par if they are not required to do so. If the transaction explanation is correct, banks will promise to pay par value only if the deposits are used in transactions. After the survey of the theoretical literature, we examine the history of banking in several countries in different eras: fourth-century Athens, medieval Italy, Japan, and free banking and money market mutual funds in the United States. We find that all of the theories can explain some of the observed banking arrangements, and none explain all of them.

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Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 180c.

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Date of creation: 2004
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Handle: RePEc:red:sed004:180c

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Cited by:
  1. Gerald P. Dwyer & Paula Tkac, 2009. "The financial crisis of 2008 in fixed income markets," Working Paper, Federal Reserve Bank of Atlanta 2009-20, Federal Reserve Bank of Atlanta.
  2. Nelson, Edward, 2013. "Friedman's monetary economics in practice," Journal of International Money and Finance, Elsevier, Elsevier, vol. 38(C), pages 59-83.
  3. Hasman, Augusto & Samartín, Margarita & Bommel, Jos Van, 2013. "Financial contagion and depositor monitoring," Journal of Banking & Finance, Elsevier, Elsevier, vol. 37(8), pages 3076-3084.

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