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Why do banks promise to pay par on demand?

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  • Margarita Samartín
  • Gerald Dwyer

Abstract

We survey the extant theories on why banks promise to pay par on demand and examine historical evidence on 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 three strands: liquidity; asymmetric information; and regulatory restriction. One strand of the literature argues that banks offer to pay par on demand in order to provide liquidity insurance services to consumers who are uncertain about their future time preferences and who have investment opportunities inconsistent with some of their preferred consumption paths. A common assumption needed in most of these papers is that demand deposits cannot be traded, which suggests regulatory restrictions that prevent banks and active markets coexisting. A second strand of the literature argues that banks offer to pay at par as a way to protect uninformed depositors, who would otherwise be disadvantaged relative to better informed individuals if equity contracts were employed instead. The deposit is then on demand to make its value not contingent on states that are not verifiable by the depositor. In a sense, demand deposit contracts are a discipline device in this setup because the promise to pay par on demand helps to limit the riskiness of banks' activities. The third strand of the literature argues that banks promise to pay par on demand because of legal restrictions which prohibit other securities from playing the same role as demand deposits. We conclude that there are sharp predictions by the relevant theories. 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 antecedent conditions in the theories are possible explanations of the reasons for the banks promising 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. After the survey of the theoretical literature, we examine the history of banking in several countries in different eras: fourth century Athens, medieval Italy, the Netherlands, Great Britain, the United States and Japan. We have some preliminary conclusions for Athens in antiquity and medieval Italy. The evidence from antiquity is informative because it is far in time from contemporary practice, even though the evidence is too uncertain to be compelling by itself. Nonetheless, from the viewpoint of the legal restrictions theory, this period is troubling because there is no evidence that banks were required to pay par on demand and there is evidence that they did so. At least for some of their deposits, such a contract was optimal and that optimality is consistent with the asymmetric explanation and probably the liquidity explanation for banks' promise to pay par on demand. It is clear that, as early as 1100 A.D., banks in Italy accepted deposits payable on demand and it is clear that they were not required to do so, since they also accepted deposits that could be redeemed only with notice, e.g. fifteen days (de Roover 1974). Hence, legal restrictions appear to be irrelevant. The evidence indicates that the loans made were not the sort that would have a transparent value to depositors, so deposits being payable on demand is consistent with the asymmetric information theory. On the other hand, these banks also accepted deposits redeemable only with notice and these deposits were claims on the same asset pool as were the demand deposits. There is a clear difference in the maturity of the demand deposits and loans such as for foreign exchange, which is consistent with the liquidity theory

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 372.

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Date of creation: 2004
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Handle: RePEc:red:sed004:372

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Keywords: Asymmetric information; deposit contracts; liquidity; regulation;

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References

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Cited by:
  1. Hasman, Augusto & Samartín, Margarita & Bommel, Jos Van, 2013. "Financial contagion and depositor monitoring," Journal of Banking & Finance, Elsevier, vol. 37(8), pages 3076-3084.
  2. Edward Nelson, 2011. "Friedman's monetary economics in practice," Finance and Economics Discussion Series 2011-26, Board of Governors of the Federal Reserve System (U.S.).
  3. Gerald P. Dwyer & Paula Tkac, 2009. "The financial crisis of 2008 in fixed income markets," Working Paper 2009-20, Federal Reserve Bank of Atlanta.

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