Demand Deposits and Bank Monitoring

Abstract

This paper provides a novel rationale for why banks combine lending and deposit taking. Contrary to existing work, it shows that demand deposits commit banks to monitoring even if deposit insurance is implemented. Investors with liquidity needs withdraw their deposits early and are not willing to re finance a bank. Early withdrawals curtail excessive bank lending and thereby commit a bank to monitoring. In contrast, banks with coupon bonds can refi nance in the interim stage and expand on risky lending, which derails monitoring. This finding speaks against the separation of bank lending and deposit-taking put forward by narrow banking proposals. It is also shown that a liquidity tax may shorten the maturity of bank liabilities and may act procyclically.