Why do Banks Promise to Pay Par on Demand?

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(This abstract was borrowed from another version of this item.)