Chapter 12 - The Deposit Contract, Deposit Insurance, and Shadow Banking

Abstract

This chapter turns to the liability side of the bank’s balance sheet and discusses the deposit contract, deposit insurance, and shadow banking. We begin with a discussion of the economics of the demand deposit contract, and illustrate the economics with a numerical example. Then we discuss liability management, followed by deposit insurance as a way to reduce the likelihood of runs on banks. A numerical example is used to illustrate the key concepts. How deposit insurance should be priced using an option pricing approach is discussed next. Since deposit insurance can cause moral hazard, we discuss the empirical evidence on moral hazard and the S&L crisis in the 1980s as an illustration of how this moral hazard can lead to systemic problems. The chapter closes with a discussion of “shadow banking” and its relationship to traditional commercial banking.